Raising capital is one of the most critical challenges facing early-stage startups in Malaysia. While traditional equity financing remains popular, convertible notes have emerged as a flexible and founder-friendly alternative that bridges the gap between seed funding and a formal priced round. This guide explores the legal considerations surrounding convertible notes in Malaysia, helping founders and investors navigate this increasingly common financing instrument.
What Is a Convertible Note?
A convertible note is a form of short-term debt that converts into equity at a future date, typically upon the occurrence of a qualifying financing round. Instead of immediately determining the company's valuation—which can be difficult and contentious at the early stages—both parties agree to defer that decision until the startup has more traction and a clearer picture of its worth.
In essence, an investor lends money to the startup with the understanding that the loan will convert into shares rather than being repaid in cash. This mechanism provides startups with quick access to capital while giving investors the opportunity to participate in the company's future equity upside.
Key Terms in a Convertible Note Agreement
Understanding the fundamental terms of a convertible note is essential for both founders and investors. These terms define the economics of the deal and the conditions under which conversion occurs.
Principal Amount and Interest Rate
The principal amount is the sum invested by the noteholder. Malaysian convertible notes typically carry an interest rate, often ranging from 4% to 8% per annum. This interest accrues over the life of the note and is added to the principal at conversion, meaning investors receive additional shares to account for the time value of their money.
Maturity Date
The maturity date specifies when the note must either convert or be repaid. Common maturity periods range from 18 to 24 months. If a qualifying financing event has not occurred by this date, the parties must negotiate an extension, conversion at agreed terms, or repayment of the principal plus accrued interest.
Discount Rate
The discount rate rewards early investors for taking on greater risk by allowing them to convert their notes into equity at a price lower than what later investors pay. A typical discount ranges from 15% to 25%. For example, if Series A investors pay RM10 per share and the convertible note carries a 20% discount, noteholders would convert at RM8 per share.
Valuation Cap
The valuation cap sets a maximum company valuation at which the note will convert, protecting investors from excessive dilution if the startup's value increases dramatically before conversion. If the company raises its next round at a valuation higher than the cap, noteholders convert at the cap instead, securing a larger ownership percentage.
Qualifying Financing Threshold
This term defines the minimum amount that must be raised in a subsequent financing round to trigger automatic conversion. The threshold ensures that conversion only occurs during a meaningful funding event, typically set between RM1 million and RM5 million for Malaysian startups.
Conversion Mechanics Under Malaysian Law
The conversion of debt to equity in Malaysia must comply with the Companies Act 2016 and any relevant provisions in the company's constitution. Several legal considerations come into play during this process.
Share Allotment Requirements
When a convertible note converts, the company must allot new shares to the noteholder. Under Section 75 of the Companies Act 2016, directors must have the authority to allot shares, which may require shareholder approval depending on the company's constitution. Startups should ensure their constitutional documents provide sufficient flexibility for future share issuances.
Stamp Duty Considerations
The issuance of shares upon conversion may attract stamp duty under the Stamp Act 1949. While the original note itself may not be subject to significant stamp duty, the subsequent share transfer documentation typically requires stamping. Parties should factor these costs into their planning.
Foreign Investment Restrictions
If the investor is a foreign party, additional considerations apply. Certain sectors in Malaysia have foreign ownership restrictions, and startups must ensure that the conversion will not breach any applicable limits under the Foreign Investment Committee guidelines or sector-specific regulations.
Investor Protections to Consider
Sophisticated investors typically negotiate for certain protections within the convertible note agreement to safeguard their investment.
Information Rights
Investors often request periodic updates on the company's financial performance, including quarterly financial statements and annual reports. These provisions help investors monitor their investment before conversion occurs.
Pro-Rata Rights
Pro-rata rights allow noteholders to participate in future financing rounds to maintain their ownership percentage. This protection becomes particularly valuable if the startup performs well and subsequent rounds are oversubscribed.
Most Favoured Nation Clause
An MFN clause ensures that if the company issues subsequent convertible notes with more favourable terms, existing noteholders can elect to adopt those improved terms. This protects early investors from being disadvantaged by later deals.
Change of Control Provisions
These clauses address what happens if the company is acquired or undergoes a significant change of control before the note converts. Typically, noteholders can either convert immediately at favourable terms or receive a multiple of their principal investment.
Practical Advice for Malaysian Startups
Before issuing convertible notes, founders should engage qualified legal counsel to draft or review the documentation. Poorly drafted notes can lead to disputes, unexpected dilution, or regulatory issues down the line.
Maintain clear records of all convertible notes issued, including the key terms and any amendments. As your cap table grows more complex, accurate record-keeping becomes essential for future fundraising and due diligence processes.
Consider the cumulative effect of multiple convertible notes. Stacking notes with different caps and discounts can create a complicated conversion scenario that significantly dilutes founders when a priced round eventually occurs. Model various scenarios to understand the potential impact on your ownership.
Finally, communicate openly with your investors about the company's progress and any challenges. Strong investor relationships built during the convertible note stage often translate into continued support during subsequent funding rounds.
Conclusion
Convertible notes offer Malaysian startups a practical and efficient means of raising early-stage capital without the complexity of a full equity round. However, both founders and investors must understand the legal framework governing these instruments and negotiate terms that balance flexibility with appropriate protections. With careful planning and proper legal guidance, convertible notes can serve as an effective stepping stone in a startup's growth journey.
Disclaimer: This article provides general information only and does not constitute legal advice. The content is intended for educational purposes and should not be relied upon as a substitute for professional legal counsel. Laws and regulations may change, and the application of legal principles varies based on individual circumstances. For advice specific to your situation, please consult a qualified lawyer.