Investment activity, in general, poses significant capital loss risks to investors; venture investing, in particular, also requires consideration of the urgent need for a substantial initial investment inflow in high-tech start-ups. In response, legislative alterations have introduced mechanisms such as option agreements (“Option”) and convertible loan agreements (“CLA”) into the Russian legal system in 2015 and 2021 respectively. The latter gives the investor a choice of reclaiming the made contribution as a loan when a start-up fails or, otherwise, becoming a shareholder (“Shareholder Right”).
This article will present a comparative analysis of the mechanisms above and the peculiarities of their implementation based on Russian corporate law and entrenched judicial practice.
The Option vests the investor with the future right to enter into a sale and purchase agreement of the company’s shares (“SPA”) at a fixed price by accepting the irrevocable offer directed by the Option seller. Protection of the investor’s rights is guaranteed by (i) the irrevocability of the offer and (ii) the unilateral nature of the acceptance right. The investor may follow put or call Option scenarios within venture investing.
The Call Option lets the investor take a so-called wait-and-see position and fulfill its Shareholder Right provided the company achieves the anticipated financial results (profit level, KPI, etc.). Thus, there is a possibility of fixing the share price (“Strike Price”) and, in turn, excluding the burden of foreign exchange rate and market fluctuations at the acceptance date.
By entering a Put Option, the investor already holding a company’s share reserves a so-called exit right if the company does not reach the anticipated financial results. Thus, the investor is entitled to have the company buy back its share at the Strike Price and, as a result, hedge the risks of future price fluctuations.
The CLA entitles the investor to choose whether to become a shareholder or reclaim the contribution made as a loan.
The set-off of the investor’s loan requirements against its obligation to pay the shares’ amount when entering the start-up fulfils the shareholder’s right. This right is based on the unanimous decision of the general meeting/sole shareholder to increase the charter capital of the company or issue additional shares in case of a limited liability company (“LLC”) and a joint-stock company (“JSC") respectively, on the ground of the investor’s application.
At the same time, the investor implements the conversion right by directing the relevant requirement of the charter capital increase or additional shares’ issuance to the notary public or the registrar, respectively, provided the term is due and the conditions set out in the CLA are fulfilled.
Still, before 2021, the CLA mechanism applied via the conclusion of a loan agreement accompanied by entering into a shareholders’ agreement and the Option as well as a set-off agreement.
The introduction of the CLA as a separate agreement (i) provides automatic conversion unless the borrower claims its objection towards the investor’s entry into the company, and (ii) makes conversion more transparent due to the obligation to register the CLA in the Russian legal entities’ registry (“USRLE”).
On the other hand, the newly introduced CLA triggered certain risks for the investor. Firstly, in case of objection from the borrower, the investor’s shareholder right is at risk of being blocked due to the mere fact of the objection’s submission to the notary public or the registrar. At the same time, the CLA claims fall under the exclusive jurisdiction of state courts without the right to arbitrate.
Firstly, in contrast to the Option concluded between shareholders and investors, in the case of the CLA, the start-up itself is the CLA party. Thus, the prerequisite of the CLA conclusion is a start-up’s state registration.
The CLA requires additional steps once the Parties fulfill the Option conditions and conclude the SPA by accepting an irrevocable offer. These steps may include the charter capital increase or the issuance of additional shares and must be followed up by the registration of relative changes in the company’s articles of association.
Furthermore, unlike the Option conclusion, the CLA is subject to state registration with the USRLE.
Overall, the Option seems more favorable from the investor’s point of view than the CLA mechanism. Such an inference is drawn from (i) the CLA borrower’s right to block the investor’s Shareholder right, (ii) strict terms of the CLA set out by the law, and (iii) an ensuing need to resort to additional corporate mechanisms to protect the investor’s interests under the CLA.
