Convertible instruments allow investors and founders to postpone a valuation discussion. They do not eliminate it. The instrument's conversion formula, repayment rights and relationship with the Companies Act can materially change the percentage ownership ultimately delivered to investors.
The instrument must have a clear legal character
A convertible note may create a debt obligation with an option or mechanism for conversion into equity. Other instruments may promise shares upon a future funding event without ordinary debt features. Their legal and regulatory treatment depends on the actual terms and the issuer's corporate powers. Borrowed terminology from a foreign standard form should not be assumed to operate automatically in Pakistan. Counsel should identify whether the company may issue the contemplated instrument, which approvals are required and how the future allotment will be implemented.
Conversion arithmetic needs worked examples
A discount or valuation cap affects the share price at which the investment converts. The calculation should define pre-money or post-money treatment, fully diluted capital, option pools and existing convertible instruments. Founders and investors should model a successful funding round, a smaller round and an exit before any qualified financing occurs. An unclear formula can lead to contradictory claims over the number and class of shares due. The contract should also state how fractions, accrued interest and adjustment events are handled.
Failure to raise another round must be addressed
An instrument that converts only on a future financing can remain unresolved for years. The parties should provide for maturity, extension, repayment or alternative conversion, recognising that repayment obligations may strain a startup without stable cash flow. The rights arising on sale or liquidation should also be specified. A preference drafted to protect the investor may have different consequences depending on whether the transaction is an asset sale, share sale or insolvency. Silence creates disputes at the point when capital is most urgently needed.
Corporate implementation is not automatic
The future conversion may require authorised capital, share allotment procedures, waiver or observance of pre-emption rights and changes to the articles or shareholder arrangements. The company should not promise an allotment that its existing documents prevent without an agreed route to amendment. Foreign investor reporting, tax and regulated-business restrictions may also be relevant. Accurate records of money received, conversion notices and share certificates are essential once conversion occurs.
A conversion formula is a binding bargain
Convertible finance works when the conversion mechanics are understandable before the triggering event. The parties should model dilution and legal implementation together. Postponing valuation does not justify postponing decisions about investor rights, corporate approvals and failure scenarios.
When the issue arises in practice.
Our advice begins with the governing documents, the legal position and the decision that needs to be made.
DISCUSS THIS MATTERThis publication is for general information and does not constitute legal advice on any particular matter.