What should a startup check before signing a convertible loan?

A Pakistani startup considering a convertible loan must examine both the debt obligation and the legal mechanism by which the lender may become a shareholder. A convertible loan is not automatically equity on signing. It may require repayment of principal and profit or convert into shares on an agreed event, often a qualified financing round, maturity or another specified trigger. The terms must comply with the Companies Act, 2017, the company's articles, applicable issue-of-shares rules, tax provisions and any foreign exchange requirements.

Identify what instrument is being offered

A convertible note, convertible loan, advance against future equity and straightforward share subscription can have different legal effects. The document should state whether funds are debt, equity or another legally defined arrangement before conversion. Marketing the investment as "almost shares" does not establish ownership. Investors should understand their rights before conversion, including repayment, security, information access and what happens if the startup never raises another financing round.

Principal and repayment obligation

The loan should specify principal amount, drawdown conditions, due date and circumstances requiring repayment. Some startups assume repayment will never be requested because investors expect conversion. That assumption can be dangerous if conversion does not occur. The borrower should model the ability to repay on maturity or negotiate a lawful extension mechanism. A lender should distinguish promised returns from legally enforceable debt terms and avoid vague statements about future fundraising.

Conversion events

A qualified equity financing can trigger conversion where a financing round meets an agreed threshold. Other events may include an exit, change of control or maturity. The contract should state whether conversion is automatic or requires action by one party, and what corporate approvals are needed. An investor should not assume a convertible loan becomes shares merely because another investor expresses interest. The precise event and timing must be defined.

Valuation cap

A valuation cap can set an upper valuation reference for calculating conversion shares, potentially benefiting the note investor if the next financing is priced higher. It is not necessarily a guaranteed value of the company or a cash redemption entitlement. The drafting must define whether the cap applies on a pre-money or post-money basis and how the fully diluted capitalization is calculated. Ambiguity can materially alter percentage ownership.

Conversion discount

A discount may allow the note to convert at a lower price than investors in a later qualifying round. For example, an agreed twenty-percent discount affects the conversion price, subject to the exact formula. The document must address how discount and valuation cap interact and which produces the applicable price. Without clear drafting, parties may dispute the number of shares when the financing closes. A working capitalization table should accompany the agreement.

Interest and accrued return

If the instrument carries interest or other financial return, specify calculation, compounding, maturity and treatment on conversion. Does accrued interest convert into shares or remain payable? A company should evaluate tax and regulatory implications and should not assume any return formula is enforceable simply because it is common in foreign startup templates. Islamic finance structures may require a different legal and Shariah analysis.

Section 83 of the Companies Act

Further issue of shares by a Pakistani company is subject to section 83 of the Companies Act, 2017 and its amendments. Existing shareholder rights, permitted offerings to others and required resolutions must be assessed. A contractual conversion promise cannot automatically override a mandatory statutory allotment process. The startup should plan from the outset how conversion will be lawfully approved and how any pre-emption or investor-consent rights will be addressed.

Authorised capital and classes of shares

The company must have the corporate capacity to issue the shares contemplated or complete any lawful capital changes first. The investor should identify whether conversion produces ordinary, preference or another permitted class of shares, with exact voting and economic rights. A note that says "convert into the investor's preferred shares" without a defined class may cause major disputes. Articles and shareholder agreements should align with the promised rights.

Pricing and issue regulations

The Companies (Further Issue of Shares) Regulations, 2020, as amended through January 2026, may be relevant to the transaction. Private company issues, valuation, non-cash consideration and special approvals should be checked under the current consolidated text. Conversion of a debt obligation into shares should be structured with appropriate documentation and accounting treatment. A startup should not simply cancel a loan ledger and update an informal spreadsheet as though statutory allotment were complete.

Foreign investment considerations

Where the lender is nonresident, foreign exchange, repatriation and SBP reporting rules may affect the loan, conversion and eventual exit proceeds. A foreign currency loan and a direct equity investment are not necessarily treated identically. Before accepting funds, the company should verify the permitted route, receiving bank's documentation and any regulatory approval or registration requirements. A template created for Delaware corporations may not address Pakistani exchange-control obligations.

Tax and financial reporting

The company should examine whether principal, accrued return or conversion causes income tax, withholding or accounting consequences. The legal character of the instrument matters to recognition as debt or equity. Investors should also consider capital gains and dividend treatment after conversion. A speculative assertion that conversion is tax-free can create later exposure. Qualified accountants and tax counsel should reconcile the legal contract with financial statements and statutory returns.

Investor information and consent rights

Convertible lenders sometimes negotiate reporting, reserved matters, negative pledges or the right to approve future borrowing. Those provisions can restrict management before conversion despite the lender not yet being a shareholder. A startup should ensure the restrictions are proportionate and do not paralyse ordinary operations. The investor should understand whether governance rights terminate, survive or change after conversion. Separate shareholders' agreement accession may be required.

Maturity without a financing round

The agreement should address what happens if no qualified financing occurs before maturity. Options may include repayment, extension or conversion under a separately defined formula, subject to law. An investor's unilateral right to force conversion at an arbitrary valuation can create corporate and regulatory difficulties. A startup unable to repay may face default and insolvency risks if the note remains debt. The consequences should be modelled before signing.

Change of control and sale

If the startup is sold before conversion, the lender may seek repayment, a specified premium or conversion into equity immediately before exit. Each route produces different economic results and may affect the acquisition. The agreement should define the transaction, entitlement and order of payments. A buyer will review all notes as part of due diligence. An ambiguous exit clause can delay or prevent a sale even where founders and ordinary shareholders agree.

Security and ranking

A convertible loan may be unsecured, subordinated or supported by guarantees or collateral. Its ranking relative to existing creditors matters in an insolvency or recovery scenario. A founder should not assume convertible investors rank as ordinary shareholders before conversion if the obligation remains debt. Conversely, a note holder should understand any subordination and the company’s existing security arrangements. A new lender may require negative pledge or intercreditor consent.

A financing-round example

A startup receives Rs. 20 million under a note with a valuation cap and discount. One year later it raises priced equity financing. The company must apply the agreed formula, determine the fully diluted share count and comply with corporate approval and allotment procedures. The investor's economic percentage can differ substantially depending on whether the cap is pre-money or post-money. The conversion spreadsheet should be reviewed before the new shares are issued.

A failed fundraising example

A startup spends its funds developing a product but does not obtain another financing round before note maturity. The investor demands repayment. If the contract makes principal due, the founders cannot automatically refuse because everyone initially expected eventual equity. The company should examine extension and restructuring options before default. The parties may agree lawful conversion or waiver, but actual corporate approvals and investor consent remain necessary.

Opinion and recommended course

A convertible loan can bridge funding rounds but creates significant debt, dilution and compliance risks if conversion is poorly drafted. Specify triggers, pricing, maturity, default, governance and foreign investment terms, and align all promises with section 83 and the current issue-of-shares rules. Maintain a transparent capitalization model and verify tax and regulatory consequences before receiving funds.

Principal authorities: Companies Act, 2017, especially section 83; Companies (Further Issue of Shares) Regulations, 2020 as amended; Companies Regulations, 2024; Contract Act, 1872; Income Tax Ordinance, 2001; applicable State Bank foreign exchange regulations and the company's articles.