AN INTRODUCTION TO CONVERTIBLE LOANS

When startups 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. On this page, you’ll find the basic information that investors need to know about convertible loans, the most common financing form besides equity.

WHAT IS A CONVERTIBLE LOAN?

Convertible loans are loans that will be converted into shares of the company later. Setting up a financing round with a convertible loan is simpler and faster than doing an equity financing round. The negotiations with investors and formalities for an equity round usually take several months, drafting the paperwork associated with it will keep lawyers busy, and the resulting capital increase necessitates an entry in the commercial registry after a notary meeting. Compared to this, a convertible note is less work.

An introduction to convertible loans - Verve Ventures

WHAT'S THE DIFFERENCE BETWEEN INVESTING IN EQUITY OR A CONVERTIBLE LOAN

  • Convertible loans are a form of debt financing. They will appear on the balance sheet as liabilities, and the investors become creditors of the company (unlike equity investors who become shareholders). Should the startup go into liquidation, the proceeds will first be used to repay the creditors (loan holders).
  • Bank loans need to be paid back. Convertible loans aren’t designed to be paid back (Cash reimbursement is usually only foreseen in case of dissolution or insolvency of the company even though sometimes, a payback clause can be found in the contracts).
  • Many venture capital firms don’t want to invest in convertible loans as their first investment in a startup because unlike with equity financing, convertible loans don’t grant a say in company decisions.

You can find more details in this article.

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A CONVERTIBLE LOAN DOESN'T GIVE YOU A VALUATION OF THE COMPANY

When you invest in equity, you know at what price you buy shares of the company. An equity financing round puts a price tag (the valuation) on the whole company.

When a startup issues a convertible loan, there is no valuation of the company at that moment. As an investor in a convertible loan, you don’t know at what valuation you invest, and you don’t know yet at what price per share your capital will be converted into shares in the future. You do, however, know how high the reward for this uncertainty is (mainly in the form of a discount, more on this later).

The discount is the main reward for investors. It is expressed in a percentage, say, 10% to 20% (which are figures we see frequently). The next qualified equity financing round will establish a valuation of the shares. Investors get a 20% reduction on that price. If the share price of the next round is EUR 10, convertible loan investors will be able to convert their capital at a price of EUR 8 into shares, giving them more shares of the same share class as new investors. If you invested EUR 10’000 in the convertible, you’ll receive 1250 shares in the equity financing round, while other investors that only invest in the equity round would receive 1000 shares for EUR 10’000.

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  • Interest: Usually the convertible loan also carries interest, say, 2% (or a similar figure corresponding to current interest rates), that will accrue from the date of the investment until the conversion date. Sometimes, the rate is 0% but it can also be as high as 10% if the startup is in a weak position. In any case, the rates usually seen in convertible loans are considerably lower than what a bank loan for such a company might be if it would be available.
  • Qualified Financing: The size of the financing round that will trigger the conversion is set with a minimum amount, for example, “gross proceeds to the company of at least EUR 5 million”. If the company doesn’t manage to raise this amount in the next financing round, the conversion will usually not take place automatically, but the investors get to choose if they want to convert the loan into shares or not. (Choosing not to convert generally makes little sense for the investor.)
  • Maturity date: This date determines the deadline when the loan can/has to be converted even if no “qualified financing” took place beforehand. Again, in this case, it’s usually up to the investors to decide whether they want the conversion or not.

Read this eBook to learn all the relevant terms about convertible loans.

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  • The most promising startups can choose their future shareholders, not vice versa.
  • Efficient fundraising and the importance of ticket size.
  • Limited investable space.
  • Direct access only at the seed stage.

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