Convertible Loan: How It Can Help Startups in Russia

Contents:

• Convertible loan: what is it?
• Advantages and features of a convertible loan
• Key changes in corporate governance procedures
• Changes in the practice of convertible loans
• Advantages of the new law on convertible loans
• Doubts about the new legislation: the view of entrepreneurs
• Dissatisfaction in the venture community

Convertible loan: what is it?

A convertible loan is an important financial instrument that allows investors to provide capital to early-stage startups without having to evaluate their business. Such funds can be used by founders at their own discretion, which provides flexibility in financial management. In the future, investors have the option to convert their loans into shares or a stake in the company, which makes this instrument attractive. The terms, including the loan conversion period, are fixed in the agreement, which provides clarity for both parties. Investors also get the opportunity to purchase securities at a discount, allowing them to increase their stake in the company on favorable terms. A convertible loan is becoming an effective way to attract investment for startups and gives investors the opportunity to participate in their growth.

Since the entry into force of Federal Law 354-FZ on July 13, 2021, the number of convertible loan transactions in Russia has not reached the projected level. This opinion is shared by market participants, including experts from Skillbox Media. The worsening situation in the financial market and a lack of information about new instruments may be the reason for the low interest in convertible loans. It is important to note that the development of this segment may have a significant impact on the investment climate in the country.

Advantages and Features of a Convertible Loan

The legislation concerning convertible loans is the result of many years of collaboration between legislators, venture capital representatives, and industry experts. Alexandra Orekhovich, Director of Legal Initiatives at the Internet Initiatives Development Fund (IIDF), emphasizes that the development of this law lasted more than four years and included the analysis and adaptation of best global practices. This legislation is designed to ensure a more transparent and secure environment for investors and startups, promoting the development of an innovative economy.

The modern process of concluding an agreement requires a general meeting of the company's co-owners. At this meeting, participants must agree on the terms of the loan and determine the new investor's shareholding. In addition, increasing the authorized capital through loan conversion is discussed. In the case of a joint-stock company, after signing the agreement, the issue of additional shares must be registered. Correct execution of these steps is the key to successfully attracting investment and sustainable development of the company.

After the completion of the transaction, the notary confirms the decision of the general meeting and informs government agencies, including the tax office. The contract details must be registered with the Unified State Register of Legal Entities (USRLE), but this is currently not possible, according to lawyer Dmitry Kazakov. It is important to remember that proper registration and notification of government agencies play a key role in the legitimacy of the transaction and the protection of the parties' rights.

After the specified period, the investor must contact a notary or registrar to formalize their rights to repay the loan, share, or stock. The notary notifies the company of the investor's intentions, which in turn has 14 business days to agree or raise objections. In case of refusal, the investor has the right to go to court to protect their interests.

Key Changes in Corporate Governance Procedures

Important changes have recently occurred in the legislation concerning the voting of company participants. Voting is now conducted at the initial stage, which allows for early decision-making. Furthermore, notarization of transactions has become mandatory, significantly reducing the risk of fraud and increasing trust between parties. These changes create a more transparent business environment and strengthen legal guarantees for participants. Orekhovich, a corporate law specialist, emphasizes that this practice brings significant benefits to both parties. Investors gain confidence in their shares, as all necessary decisions by the founders are made before signing the convertible loan agreement. This significantly reduces risks and allows them to focus on achieving the key performance indicators outlined in the agreement. This approach not only increases trust between the parties but also facilitates more effective investment management.

This mechanism for raising capital for startups represents a significant breakthrough. It enables the rapid and efficient acquisition of funds while maintaining flexibility in company management. As Orekhovich notes, such changes are critical to the successful development of start-up businesses. This approach allows startups to adapt to changing market conditions and respond more quickly to challenges, ultimately contributing to their sustainable growth and competitiveness.

Notarization provides an additional level of security for real estate transactions. The notary records the terms of the transaction and notifies all co-owners of the new participant. The documents are then submitted to Rosreestr for official registration. Lyudmila Golubkova, CEO of the management company Astarta Capital, notes that notarization significantly simplifies and speeds up the transaction process, which is especially important in today's real estate market.

Changes in Convertible Loan Practice

Previously, the process of formalizing a convertible loan was a truly complex undertaking. Lawyers had to use complex schemes and various civil law mechanisms to protect investors' interests. As Anna Pashutina, a lawyer at Express-Law, notes, contracts often included not only refunds but also offsets of mutual claims. This complicated the process and increased the risks for the parties. With the development of legal practice and the simplification of procedures, the registration of convertible loans has become more transparent and accessible to investors, which contributes to the growth of this financial instrument in the market.

According to the terms, upon expiration of the loan term, the investor was obliged to submit an application for entry into The composition of the company's shareholders. This procedure was often delayed, jeopardizing the investor's ability to receive their stake, according to Maxim Barashev, Managing Partner of the law firm BBNP. It's important to emphasize that at such times, many startups chose to postpone voting, creating additional risks for investors. This underscores the need for careful analysis of agreement terms and startup strategies to minimize potential losses and protect interests in an unstable environment. According to a 2023 study, 65% of startups experience delays in attracting investors. This underscores the high risks venture capital firms face. Startup founders often find themselves in difficult situations, especially when their business's value rises to billions of rubles. Refusing to pay a stake to an investor who has invested, for example, 30 million rubles, is becoming a common practice. This creates additional complications in the relationship between startups and their investors, which may negatively impact further business development and raising new funds.

Previously, the only way to guarantee an investor's share was through convertible bonds or options. In other cases, the question remained whether the investor would be able to receive their share. This underscores the need to implement clearer and more transparent mechanisms that will protect the interests of all transaction participants. The use of such mechanisms will increase trust in investment processes and allow investors to confidently assert their rights.

In the event of conflict, investors have the option of going to court; however, the recovery amount is typically significantly lower than expected. This circumstance has become one of the main reasons for reviewing existing practices and seeking safer and more effective solutions in venture capital. Streamlining legal processes and choosing alternative dispute resolution methods can significantly reduce risks and enhance investor protection.

Benefits of the New Law on Convertible Loans

A recent survey conducted by Skillbox Media showed that legislative developers and entrepreneurs evaluate the new changes favorably. Investors also note that the new law could create a more favorable environment for startups. However, not all market participants view these changes as beneficial.

Experts predict that up to 70% of investment deals, especially in the early stages, will be carried out using convertible loans. This mechanism will allow startups to more effectively raise capital for their growth and development. Alexandra Orekhovich notes that the new law creates a more favorable environment for doing business, which in turn would contribute to an increase in the number of successful startups on the market. Thus, convertible loans are becoming an important tool in the arsenal of young companies seeking rapid scaling. Lyudmila Golubkova of Astarta Capital notes that the new law gives entrepreneurs the opportunity to retain control over their businesses, reducing the influence of investors. She has repeatedly observed situations where investors seek controlling stakes. In this context, the convertible loan mechanism serves as an effective alternative, allowing entrepreneurs to avoid losing influence over their companies. This approach can significantly change the dynamics of interactions between entrepreneurs and investors, providing more flexible terms of cooperation.

Many entrepreneurs have not yet signed contracts in accordance with the new legislation, but they are confident that it will significantly simplify the investment process. The new rules expand the pool of potential investors, allowing startups to count on a wider choice without having to limit themselves to only reliable partners. This opens up new funding opportunities and facilitates business development.

In 2018, the startup Stafori, which develops AI-powered recruiters, raised 226 million rubles in the form of a convertible loan and options from the Internet Initiatives Development Fund (IIDF) and entrepreneur Georgy Semenenko. The funds were used to expand into international markets and create new products. The company's strategy includes expanding the functionality of its solutions to improve the recruitment process, which allows for increased recruitment efficiency and meets the needs of customers in various countries.

Evgeny Chernov, co-founder of PIM Solutions, spoke about the difficulties he faced when signing a convertible loan agreement with IIDF. Before making his decision, he carefully reviewed the terms of the document and consulted with lawyers. These steps were necessary because he needed investment to scale his business. Evgeny's experience underscores the importance of thorough preparation and legal due diligence before entering into financial agreements.

In 2017, PIM Solutions raised 200 million rubles in investment from the Internet Initiatives Development Fund (IIDF), which contributed to its dynamic growth. In 2019, 35 million parcels were processed through the PIM Solutions platform, and by 2020, this figure increased to 60 million. This growth confirms the effectiveness of the company's solutions in commodity data management and logistics, as well as its ability to adapt to market demands.

Doubts about the new legislation: Entrepreneurs' views

Entrepreneurs with experience working with convertible loans abroad are distrustful of the new Russian legislation. Their experience shows that transactions in foreign jurisdictions often prove more profitable and convenient. Many of them doubt that in Russia, even with the introduction of new laws, the terms of transactions will be able to become as attractive. This raises concerns about possible restrictions and shortcomings that could affect the investment climate in the country.

Mikhail Kudinov, co-founder and commercial director of Veeroute, claims that in 2017 he chose a convertible loan abroad due to the lack of the necessary legislative instruments in Russia. He emphasizes that Anglo-Saxon law already has a robust enforcement practice, which significantly reduces the risks for all parties to the transaction. This experience underscores the importance of choosing a legal system that protects the interests of investors and entrepreneurs.

Veeroute's investors, including the venture fund of Bank Saint Petersburg and a consortium of business angels, invested $1.6 million. The first tranche was provided in the form of a convertible loan. Kudinov notes that the transaction process took only three to six months, allowing the company to quickly allocate funds to product development and expanding its development team. He also emphasizes that in the current conditions in Russia, concluding such transactions is associated with high risks due to the lack of clear law enforcement practice.

Pavel Konozakov, founder of Timebook, shared his experience with investments. In 2016, at the request of a Swiss investor, he founded a subsidiary in Europe and immediately received the first tranche in the form of a convertible loan. Konozakov initially planned to return the funds, but after several successful tranches, the investor decided to forgive Timebook's debt. He emphasizes that executing a deal under such terms would have been much more difficult in Russia. Konozakov's experience demonstrates the importance of building effective relationships with investors and finding mutually beneficial solutions. Experts believe that Russian startups will continue to actively collaborate with investors from countries with the Anglo-Saxon legal system. These jurisdictions offer simplified company registration and liquidation procedures, as well as more flexible loan repayment terms. Furthermore, Western startups can take advantage of the simplified SAFE (Simple Agreement for Future Equity) agreement, developed by the American accelerator Y Combinator in 2013. This instrument allows for rapid funding while minimizing the amount of required documentation. Similar mechanisms are lacking in Russia, creating additional difficulties for local entrepreneurs. Therefore, many of them are considering entering international markets to take advantage of more favorable conditions for business development.

Concluding deals abroad can lead to undesirable consequences, warns Vitaly Polekhin, head of the Skolkovo Moscow School of Management's Investor Club. He emphasizes that Russia is actively pursuing a "deoffshorization" policy, and new legislation is aimed at returning Russian financial assets to the country. Lawmakers are seeking to motivate local investors and entrepreneurs to conduct transactions within Russia rather than abroad. This creates new opportunities for the development of domestic businesses and strengthening the country's economy.

Dissatisfaction in the Venture Community

According to a recent survey conducted by Skillbox Media, venture investors and lawyers are expressing significant dissatisfaction with the new legislative changes regarding convertible loans. The main reason for this dissatisfaction is the increased level of risk associated with their investment transactions. Legislative changes may impact deal structures and financing terms, which is causing concern among specialists in this field. It is important to consider these risks when planning and implementing investment strategies.

Lawyer Anna Pashutina emphasizes that the new loan conversion mechanism raises many questions. The risks for investors remain high, especially when a startup has the ability to reject the provision of an equity stake without documentary justification. In such cases, the investor may need to initiate legal proceedings to enforce the agreement, which can drag on for a long time. Investors should be prepared for potential legal complications and carefully assess the risks associated with such transactions.

Under the new rules, company participants must agree on conversion terms in advance. This creates the task of determining the investor's stake, which can be challenging due to unpredictable changes in revenue and the attraction of new investors. Proper understanding and agreement on conversion terms is important to ensure transparency and stability in investment relations, which will help avoid potential conflicts and ambiguities in the future.

Maxim Barashev draws attention to the important issue of changing shareholdings before the investor receives rights. When a new investor enters the company, it becomes necessary to clarify previously made decisions. This uncertainty exacerbates discontent among market participants and requires clear recommendations to minimize risks and increase transparency in investment processes. Effective management of changes in shareholdings is key to maintaining stability and trust among all stakeholders.

Discussions about the role of notaries are becoming increasingly relevant. Venture investor Lyudmila Golubkova emphasizes that notaries should only formalize transactions they understand. Unclear or complex contracts can lead to refusal to formalize them, which, in turn, complicates the transaction process. This creates additional barriers for market participants, especially in venture capital, where document clarity and transparency are critical.

The developers of the new law claim that it provides more freedom to parties to the transaction. However, many investors believe that the legislative changes complicate their interactions with startups. The new rules require additional formalization of transactions through a notary, which can lead to increased time and legal costs. This, in turn, can negatively impact the dynamics of cooperation between investors and startups, reducing the attractiveness of investing in innovative projects.

The lack of enforcement practice under the new law is causing serious concerns among lawyers and investors. Without court precedents, no one is rushing to enter into new contracts, fearing unpredictable consequences. Business angel Alexander Rumyantsev notes that he intends to await the first instances of the law's application before making an investment decision. This underscores the importance of clarity and stability in the legal environment for attracting investment and business development.

In the short term, the convertible loan market will face significant difficulties and uncertainties. This is due to the lack of positive judicial practice and the need for tax authorities to develop new forms. These factors could significantly impact investors and entrepreneurs seeking to use convertible loans as a financing tool. Without a clear legal framework and transparent tax mechanisms, the further development of this market segment remains uncertain.

Investors are gradually adapting to the new conditions. Dmitry Kazakov emphasizes that, should disputes arise, turning to Russian courts will be easier than navigating foreign legislation. He is confident that, over time, investors will master the process of formalizing convertible loans in Russia, similar to what happened with option agreements. Adaptation to new realities will reduce risks and improve the efficiency of transactions in the Russian market.