Conversion Trigger

What is a conversion trigger?

Conversion trigger (conversion event, triggering event) refers to the contractually defined event on whose occurrence a convertible loan or another convertible instrument is, or may be, converted into shares in the company. In the US market the term is used mainly for convertible notes and SAFEs. For each event, the contract also determines at what price conversion takes place and whether conversion is mandatory or optional.

Conversion events are set out in the contract for a convertible loan or a SAFE. They decide when a lender becomes a shareholder. This concerns the company and its founders, who have to plan for dilution, the lenders, whose outcome depends on the conversion price, and new investors or buyers, who expect a clear capital structure.

Typical conversion triggers in a convertible loan

Qualified financing round

The standard case is an equity round that meets the agreed minimum conditions, above all a minimum amount of new capital (qualified financing round). Mandatory conversion is usually agreed at the lower of two prices: the discount price (the round price less the agreed discount) and the cap price (the valuation cap divided by the agreed number of shares). For rounds below the threshold, many contracts provide for a conversion right of the lender or a decision by the majority of the lenders.

End of the term

If no qualified round has taken place by the maturity date (maturity date), the rule for the end of the term applies. It may provide for repayment, an extension or a fallback conversion, that is, a conversion at a valuation fixed in advance. If mandatory conversion is agreed for this case, repayment cannot be demanded on the maturity date.

Company sale and change of control

If the company is sold before a round, the lender usually receives an option. The lender can demand repayment with a premium, for example 1.5 or 2 times the loan amount, or convert at the cap immediately before closing and thus participate in the sale proceeds. Whether a sale has taken place is determined by the definition of a change of control (change of control). In addition to the sale of the majority of the shares, it should also cover an asset deal, that is, the sale of the essential business operations by transferring the individual assets. Reorganisations such as a merger also belong in the definition.

Initial public offering

An initial public offering (IPO) of a GmbH (German limited liability company) requires a change of legal form into a stock corporation (Aktiengesellschaft, AG) or another legal form eligible for listing under the German Transformation Act (Umwandlungsgesetz, UmwG). Convertible instruments are generally converted beforehand; the contract therefore expediently names the IPO expressly as a conversion event.

Share exchange and restructuring

Whether a conversion event exists when a new holding company is placed above the company, for example on a move to a US structure (flip), is unclear without a provision. The same applies to reorganisations of the company. The contract should specify whether the instrument converts in such a case, is transferred to the new parent company or is replaced by an equivalent instrument. Otherwise it may convert at an unplanned point in time or refer to a company that is no longer at the top of the group.

From conversion trigger to registration for a GmbH

Even an agreed mandatory conversion does not take effect automatically for a GmbH. The conversion event creates obligations: that of the lender to take over the new shares and to contribute its claim, and that of the shareholders to resolve the capital increase. The new shares come into existence only upon its registration in the commercial register (Handelsregister). Between the event and registration come the calculation, the notarised resolution, the declaration of acceptance and the filing.

Options shift the decision to the time of the event. They are valuable to lenders; for the company and new investors they mean uncertainty. Investors in a round therefore often require that all convertible instruments convert at closing. They make this a condition precedent (closing conditions) without which the round is not completed.

Worked example: conversion trigger on a company sale

A software GmbH has 96,000 shares on a fully diluted basis, that is, including the shares under the employee programme. An interest-free convertible loan of EUR 500,000 provides for an option in the event of a sale: repayment of 1.5 times the loan amount or conversion at the valuation cap of EUR 12 million immediately before closing. No liquidation preferences exist. The company is sold before a financing round. The buyer pays one total price for all shares. If the loan is repaid, the repayment amount is deducted from the price; if it is converted, the price is spread over 100,000 instead of 96,000 shares.

• Cap price: EUR 12,000,000 / 96,000 = EUR 125; conversion shares: 500,000 / 125 = 4,000; total shares: 100,000
• Repayment amount: EUR 500,000 × 1.5 = EUR 750,000
• Break-even of both routes: 750,000 / 4,000 = EUR 187.50 per share, that is, a purchase price of EUR 18.75 million
• Purchase price of EUR 30 million: conversion yields 4,000 × EUR 300 = EUR 1.2 million and exceeds the repayment; the other shareholders receive 96% of EUR 30 million = EUR 28.8 million
• Purchase price of EUR 15 million: conversion would yield 4,000 × EUR 150 = EUR 600,000, so the lender chooses repayment of EUR 750,000; the other shareholders receive 15 minus 0.75 = EUR 14.25 million

For the other shareholders, the option always works at the less favourable of the two values. At EUR 30 million, repayment would have left them EUR 29.25 million; at EUR 15 million, conversion would have left them EUR 14.4 million.

Distinction: conversion trigger, maturity date and AT1 conversion trigger

• Qualified financing round: the standard case among conversion events. It is a definition within the conversion rules, not their umbrella term.
• Maturity date: the due date. It is a conversion event only if the contract provides for conversion at the end of the term; otherwise it triggers repayment.
• Change of control: the definition of a change of control to which the option in the event of a sale is linked.
• Termination right: the right to end the loan early, for example for good cause. It leads to repayment, not to conversion, unless the contract provides otherwise.
• Conversion trigger for AT1 bonds: bonds counting as additional tier 1 capital of banks (Additional Tier 1) convert into equity or are written down if the common equity tier 1 ratio falls below a contractually fixed threshold. Under EU banking supervision law, this threshold must be at least 5.125%; the trigger there is a ratio, not a financing event.

Common mistakes

• Vague definition of the sale case. If only the sale of shares is covered, it remains open what applies to an asset deal or a reorganisation.
• Option instead of obligation in the round. If the lender can decide freely in the qualified round, new investors lack certainty about the capital structure.
• No rule for smaller rounds. Without a conversion right for a non-qualifying round, the loan continues to run although all parties would prefer conversion.
• IPO and restructuring not considered. If these events are missing, the contract has to be renegotiated in an already busy phase.
• Procedure overlooked. A conversion event replaces neither the resolution nor the declaration of acceptance nor the registration; without cooperation duties of the shareholders, the conversion gets stuck.

Frequently asked questions

Does a convertible loan convert in every financing round?

No. As a rule, only in a round that meets the contractual minimum conditions. For smaller rounds, many contracts provide for a conversion right or a majority decision of the lenders.

Is an IPO a conversion event?

Yes, provided the contract provides for it as such. Conversion then usually takes place before the change of legal form into a stock corporation, which precedes an IPO in the case of a GmbH.

Can a lender prevent conversion?

Not in the case of an agreed mandatory conversion, provided it has been validly agreed in the required form. The lender is then obliged to give the declaration of acceptance and to contribute its claim. If it refuses, the company can enforce the obligation in court, which however takes time and may delay an ongoing round.

Does a convertible loan also convert in a down round?

Yes, if the round meets the agreed minimum conditions. If the price per share is below that of the previous round (down round), the discount is applied to this lower price, and the lender receives correspondingly more shares. A valuation floor limiting this is rarely agreed.

What conversion triggers does a convertible note have?

In the US market essentially the same as the German convertible loan: qualified financing round, maturity and change of control. Unlike a GmbH, a US corporation can issue authorised shares by resolution of its governing body, so conversion in the qualified round usually takes place automatically there.

Who decides where there are several lenders?

The contract governs this. Majority clauses are common, under which the holders of a certain majority of the loan amounts decide for all on conversion, extension or amendments to the contract.

The Roemer Capital view

At the start of an engagement, Roemer Capital sets the conversion events of all convertible instruments side by side, because they determine what happens to those instruments in the further process. In a financing round, it checks whether the planned round reliably triggers conversion. In a sale process, the focus is on the lenders' rights on a change of control and their effect on the proceeds of the other shareholders.

The results feed into the distribution of proceeds and into the negotiation with investors or buyers. Contractual adjustments, for example to the conversion events before closing, are prepared by the company's law firm.