Understanding convertible loans and whether they are suitable for your start-up?

Friday 27th of October 2023
2:14 pm

When start-ups want to raise money, they can choose between different options. The most commonly used instrument is equity, but other sources of financing, such as debt, grants, SAFEs, and convertible loans, are frequent, too. This article explains what you need to know about convertible loans, the less common financing form after equity.

Do you need to issue a convertible loan?

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Please continue reading this post if you are curious about basic information on convertible loans and whether it is the correct type of funding for your business.

Convertible loan versus equity as methods of investing

Before we dig into individual terms, it is essential to distinguish between the two most common methods of investing: equity investments and convertible loans. In an equity investment, an investor receives a stake in the company in exchange for cash. Plain and simple. Suppose the investor provides a convertible loan instead. In that case, he will give a loan with a maturity date, interest, and a unique twist: the right to convert the loan into an equity stake in the company at some point in the future.

This post aims to cover the convertible loan – generally the less commonly used investment method. Nonetheless, it typically contains just a few terms that can easily be covered in a single post.

Definition of a convertible loan

As mentioned above, a convertible loan is a short-term debt that converts into equity. Usually, it converts at the next investment round. For example, if you receive your seed investment as a convertible loan, it will convert to equity when you raise your Series A investment.

The advantage from an entrepreneur’s perspective is that a convertible loan, before its conversion, behaves very much like a standard loan: the investor typically does not have many of the rights of a preferential shareholder (board seats, liquidation preferences, etc.). Since it is a relatively short and straightforward document, it also gets executed faster (that’s why convertible loan investment can be processed more quickly than equity investment, typically by a couple of weeks).

Additionally, a standard convertible loan does not require an immediate interest payment. Instead, it gets accrued and converted to equity, as explained below.

The disadvantage also comes from the very nature of the loan. Until the loan gets converted to equity, the investor has a priority right at the maturity date to claim any assets (i.e., cash & hardware for most start-ups) to repay the loan and interest. Most start-ups need more money to repay the loan at maturity and thus are forced to liquidate all assets and close the business.

Why and when to use a convertible loan

There are a couple of scenarios when somebody can use a convertible loan. First, it may serve as a “bridge financing” source before an anticipated significant financing round. Say you raised a EUR 200,000 seed round and are now in the process of raising EUR 2 MM Series A but still need a few more months to complete the round. So, you take a EUR 100,000 convertible loan as an extra cushion for fundraising. As mentioned above, convertible loans are faster to execute from a legal perspective, so the whole transaction can be processed in a few weeks.

Bridge financing can be tricky, though: if investors are not 100% convinced that things are going well, asking for a quick convertible loan may give rise to significant concerns regarding performance and outlook (i.e., the question: why would you need more cash to fundraise?). Losing existing investors’ confidence is the wrong way to start fundraising.

Second, the convertible loan is used when investors and entrepreneurs can’t agree on valuation, especially when they define a conversion discount but not necessarily the valuation cap (explained below).

Such a strategy can easily backfire, creating nasty arguments between investors and entrepreneurs, which can block further fundraising and thus kill a start-up.

Convertible loans are also increasingly being used at the seed stage. There is plenty of criticism against this practice from VCs, especially if the notes are overused and include harsh terms.

Terms you can find in a convertible loan

Maturity date

This is the time by which the loan matures. The first thing to understand is that the investor can require the repayment of the loan at the maturity date. If the start-up is not doing well, the investor can still recoup his investment and interest at the loan’s maturity date (and kill the start-up if it doesn’t have enough money to repay it).

Interest rate

When a company issues a convertible loan, an interest rate is specified in the loan agreement. This rate may be fixed or variable and may vary depending on the terms of the specific convertible loan. The company issuing the convertible loan must pay the lender’s interest according to the agreed terms. Interest payments are usually made periodically, for example, annually or semi-annually. In most cases, the interest on a convertible loan is paid in cash. This means that the company pays interest in the form of money to the convertible bondholders who have invested in the company through the convertible bond.

Conversion

This essential clause describes the conditions under which the loan is converted to equity. The most typical mandatory conversion scenario is upon “qualifying financing.” Once a start-up raises more than EUR XX (i.e., raises a “qualifying financing” round), the loan gets automatically converted into equity. The most investor-friendly alternative for conversion is at any time the investor chooses, but this scenario is very rare if the start-up has raised additional capital. Typically, the investor can decide whether to convert if the start-up doesn’t raise any new money before the maturity date.

Conversion discount

The investor typically converts his loan to equity with a conversion discount in valuation compared to new investors to compensate him for the additional risk of having entered the start-up earlier than the new investors. Example: Say new investors are joining the start-up at a EUR 5,000,000 valuation. If the note has a 20% valuation discount, the holder of such a loan can convert the entire loan amount (and interest as explained above) to equity at 5,000,000 * 80% = EUR 4,000,000. A standard discount on a convertible loan is 10-30%, with 20% being the most common.

Valuation cap

In addition to a conversion discount, investors can set a valuation cap, i.e., the maximum valuation at which the loan will convert. Let’s use the example above, but say the terms also included a valuation cap of EUR 3,500,000. Without the cap, the investor would convert at EUR 4,000,000 valuation, but with the cap, the investor can convert at EUR 3,500,000.