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July 22, 2022

Convertible Note Agreements in Turkish Law

Corporate Law
Reading Time: 5 minutes

A. INTRODUCTION – What is Convertible Note Agreements?

Convertible note agreements, which were mainly developed in American Law, are applied as “Loans Convertible to Shares” in Turkish Law. In order to provide financing; in the convertible note investment type, investors lend to a start-up, which is in the seed investment stage. In this system, the loan given by the investor turns into company shares in the next or future rounds when the specified conditions are met.

The convertible note is a system in which the investor tries to ensure that the company reaches the previously agreed value by giving a loan that can be converted into stock based on the value that the investor assigns to the start-up, unlike the conventional method of independent valuation-based investments.

B. DEFINITION OF THE CONVERTIBLE NOTE / LOAN CONTRACTS AND ITS APPLICABILITY IN TURKISH LAW

Due to the prohibition of companies to acquire their own shares in Turkish Law, a convertible note agreement cannot be drafted as a standard contract in the conventional method. For this reason, the validity and execution of the relevant contract type in the Turkish legal system is based on the principle of freedom of contract in the Law of Obligations and reflects the will of the parties.

In this context, specific to Convertible Note Agreements, in the American Legal system, in a convertible note agreement made with the company, the company will keep investor’s shares within the company in return for the loan given and a structure is set up to deliver the promised shares to the investor in case of the realization of the “trigger” and/or triggering transaction event regulated in the agreement. The relevant “trigger” event can be considered as any transaction that can be decided by the parties, such as the company entering a new investment round, the end of a certain period, or the company reaching a sufficient capital or valuation rate for a predetermined criterion. In this type of agreements, it is also advised to regulate, the way in which the loan will be paid back to the investor in cases where the “trigger” event does not occur.

Therefore, in the current local practice, the condition of being a shareholder of the investor is required for registration, therefore 1 (one) share is given to the investor symbolically just before the capital increase, so the investor becomes a shareholder in the company. Afterwards, a general assembly is held with a capital increase agenda, in which the shareholders of the company, who have given loans convertible to shares, can participate in exchange for their receivables from the company for the newly issued shares.

Although it is not a well-established concept in Turkish law, with the amendment made on May 11, 2020 in the Capital Movements Circular (“Governmental Circular”), the first steps have been taken to put the concept of loans convertible to shares (convertible loan) on a legal basis. Pursuant to paragraph 12 of Article 6 of the Governmental Circular, titled “Payment of share prices in capital increase”; Regarding the foreign currency transferred to the account of the person residing in Turkey, the party to the agreement, provided that the following conditions are met, there will be no obligation to meet the conditions set forth in Article 14 of the Governmental Circular on the general rules of using foreign currency loans:

  1. There is a clear provision stating that the loan will be added to the capital within a maximum of 12 months from the date of transfer,
  2. Except for the dissolution or liquidation of the company, there is a provision stating that the said amounts will be added to the capital (not included as a loan), and
  3. There is a provision stating that the entire transferred amount will be added to the capital.

However, in this type of transaction, the matter allowed by Turkish law and allowed to be deposited into the Company account without being considered as a foreign currency loan within the framework of the Governmental Circular is the investment of a foreign investment fund with a convertible note system in a company that continues to exist in Turkey. Hence, Governmental Circular does not cover investment transactions made by Turkish companies.

In this context, it will be possible to establish an appropriate structure within the framework of the principle of freedom of contract within the scope of investments and share transfers. In practice, investors lend to start-ups through convertible note agreements, in accordance with their own valuation and predicted success, with a maturity of 12-24 months (sometimes this period may be shorter). Hereby, cash flow and financing are provided to the newly established company, and an agreement is established in favour of the company and the investor at an early stage.

Besides, in practice, a commitment to participate in the shareholders’ agreement (“SHA”) to be signed with the investors in the trigger investment round is usually added to convertible note agreements. As a result of this provision, there is no negotiation for the shareholders’ agreement with the investors investing in convertible note hence investors investing with convertible note agree in advance that they will have equal rights with investors investing in the relevant investment round.

C. AS CONCLUSION

The main purpose of the Convertible Note mechanism is to provide the cash flow of the company without being subjected to an explicit valuation at the first stage, and while this happens, the investor has the opportunity to get investment back as a shareholder in a company with a potential to increase in value. Thus, a discount is applied to the share acquisition of the investor who invests in the company at an early stage.

In the agreement, the parties make their own valuations of the company’s value, and this gives the company and the investor more flexibility to set their own terms for repayment and converting the investment into shares. In this context, it is aimed to eliminate the negotiation arising from the valuation process and share ratio, the rights of the investor in the company and the shareholder agreement in general, and to bring the investment to the company as soon as possible. Convertible Note holders are obliged to wait for the investment made in the start-ups to be converted into shares until the maturity of the convertible note, and in cases where the investment is not converted into shares even though the maturity period is over, investors have the right to demand the investment back with the determined interest.

Although the applicability of the Convertible Note within the scope of Turkish Law is controversial and limited, it is seen in practice that this mechanism is executed from time to time within the scope of “freedom of contract” originating from the law of obligations, and it is observed that the frequency of applying to related investment instruments is increasing day by day, especially considering the development of the entrepreneurial ecosystem in our country. However, it should be noted that the resolution of disputes that may arise in the Convertible Note, which is not typically regulated under the law, can be complex for the parties. Consequently, it is highly recommended to draft the Convertible Note and the accompanying SHA clauses in detail, and to seek support from a specialist legal consultant during the drafting and negotiation processes of these contracts.

Best Regards,

Kılınç Law & Consulting

Corporate
The establishment of corporations, commercial contracts, the establishment of joint ventures (JV), liquidation transactions, business law, mergers...

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