The Pitfalls of Financing Companies Through Convertible Loans

Capila poradňa

Capila poradňa

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In recent years, investments into companies through convertible loans have become more widespread in Slovakia. Convertible loans offer many advantages to the involved parties, but they also have disadvantages. In this article, we at Capila Advisory have decided to take a closer look at some of the lesser-discussed negatives associated with convertible loans.


Advantages of Convertible Loans

Convertible loans are an effective and flexible tool for investing in companies. This financing method involves an investor providing financial resources to a company in the form of a loan with a clear maturity date and an agreed interest rate. Unlike traditional loans, however, upon maturity, convertible loans do not undergo standard repayment but are converted into an equity stake in the company.

This mechanism benefits both parties involved. Companies gain the necessary funds without immediately burdening their cash flow, while investors can profit from the company’s future growth through the conversion of their loan into shares. For limited liability companies (s.r.o.), the loan converts into share capital, and for joint-stock companies, into shares.


The Other Side of the Coin

However, it is necessary to recognize potential disadvantages. Convertible loans can affect a company’s ability to secure additional financing, bank loans, or leases. Banks perceive convertible loans as debt on the balance sheet, which can make the company appear highly indebted. Even though convertible loans do not have a traditional repayment process, as they later convert into shares or share capital, banks may still see them as a burden, complicating the company’s ability to obtain further financial resources. Leasing companies might view the issue of high indebtedness in a similar light.


Risk of Gaining the Status of a “Company in Crisis”

Another important factor is how convertible loans affect a company’s financial classification under the Commercial Code. The Commercial Code defines “companies in crisis” in paragraph § 67a. When a company’s ratio of equity to liabilities is less than 8 to 100, it is considered a company in crisis. Convertible loans typically worsen this ratio, as they are recorded as part of the liabilities on the balance sheet. If a company has previously incurred higher losses (or, for example, has low share capital), these losses (or low share capital) can further worsen this ratio, leading to the classification of the company as a “company in crisis”.


What Does It Mean for a Company to be Classified as a “Company in Crisis”?

When a company is classified as a “company in crisis,” certain legal restrictions apply, including the prohibition of returning “substitute performance for own resources” along with accessories and contractual penalties. The term “substitute performance for own resources” mainly refers to loans or similar performance (according to § 67c). The prohibition of return mainly applies to members of the statutory body, employees under the direct managerial authority of the statutory body, procurators, heads of organizational units, members of the supervisory board, owners with a direct or indirect shareholding representing at least 5% of the share capital or voting rights in the company, silent partners, or close persons.

In other words, if, for example, a company director (or his wife) provided a loan to the company and wanted to take these resources back, it would not be possible if the company is in crisis. If they decided to return their loan back, the value of the performance provided in violation of the prohibition must be returned to the company (§ 67f). Members of the statutory body who performed their function at the time of providing performance in violation of the prohibition are jointly and severally liable for its return (§ 67f).

In addition to legal restrictions, the classification of a “company in crisis” can have other unpleasant consequences. Many grant schemes, funds from the European Union, or other public money are typically tied to “healthy companies” (from the state’s perspective) and typically exclude applicants classified as a “company in crisis.” If your company plans to apply for a grant from public funds and has previously taken a convertible loan, check first if the company is not classified as in crisis according to legal criteria.


How to Get Out?

If a company reports that it has become a company in crisis due to a convertible loan, it is not the end of the world. This classification can be removed in several ways, either by discussing with the investor and changing the form (completely or partially) of the existing convertible loan, for example into an investment in share capital or capital funds, or into other components of the company’s equity. An alternative solution is the entry of another investor or strengthening existing investors (in a form other than a convertible loan). It is also possible to reassess whether part of the liabilities can be reduced. Lastly, the company sheds this classification upon the conversion of the convertible loan.


Capila emphasizes the importance of proper setup and planning of financing to minimize risks and ensure long-term success and stability for the company. We recommend that companies thoroughly assess the need for additional financing and the potential impact on their financial indicators before committing to this type of financing.

For more information and detailed advice, contact Capila at [email protected].


About Capila:

Capila is a Slovak company specializing in accounting services, automated reporting, and strategic financial consulting (CFO services). Experienced accountants ensure effective management of accounting and financial matters. Through our web application, clients can monitor their financial data in real time. Capila also helps clients plan and optimize their financial processes and strategies.

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