February 17, 2021

Convertible loans — Understand and then sign!

In my previous article, “Venture Debt — An attractive alternative for startups?”, I discussed the difference between venture debt and convertible loans, as most founders perceive them as the same. In this one, I aim to take a closer look at convertible loans and some specific terms that every founder should know if they consider entering such an agreement.

What is a convertible loan?

The answer can be found in the name itself. The convertible loan must be paid back like every loan, but the critical part lies in the terms of repayment: “how” and/or “when”. In most cases, the reimbursement of the debt is done by converting the loan’s value and interest into a company’s equity instead of returning the cash back. This financing option often attracts investors as it allows them to get equity later while having some protection should the startup become bankrupt before the next fundraising round. Ordinarily, the conversion happens when the startup raises a subsequent financing round. This is the reason why you might also hear the term “deferred equity” when it comes to convertible loans. If the startup does not manage to close a funding round, the convertible loan remains debt and must be paid back in cash. In this case, the debt is included in the liabilities of the startup and must be paid back at maturity. If it cannot be paid, it can result in the startups’ bankruptcy.

All of this sounds quite simple, but every founder must have a clear understanding of the conversion terms of the loan to equity to not find himself/herself in an unfavorable position after going through the struggle of raising new equity.

Why would a startup use a convertible loan?

You will often find articles mentioning the advantages of convertible loans without explaining the problems that could arise from those advantages. As mentioned previously, it all sounds simple, but it can get quite tricky if the founders misunderstand the agreement they are entering.

One of the main advantages of a convertible loan is the processing speed. It can be signed in a couple of weeks and helps founders secure money relatively fast instead of months of negotiations for equity rounds where the parties have to agree on a valuation of the startup. Founders often use this option to bridge financing rounds and receive cash quickly to cover their runway until they finish the negotiations to close their current financing round.

The issue that could arise from the situation described above is that some investors might see it as concerning that the startup needs funds to survive until the round is closed. Why does the startup have so little runway? Why did the founders not start the process earlier? Is it hard to convince other investors to join?

Another advantage of the convertible loan is that it can be done without a final valuation at the time of the agreement. This can help the founder avoid a lower valuation today if he assumes that the company’s value will increase once the next funding round is closed. A good example is if the startup can get positive results from their MVP (funded by the convertible loan) before they close the next funding round. The valuation would be higher after the MVP confirmed the market demand for the product, leading to a higher valuation.

While the benefits for the founding team seem apparent, potentially giving away less equity later, they are not that obvious for the investors. While they already have debtholders’ protection should the startup declares bankruptcy, they could also include a “Valuation cap” in the agreement, representing the maximum valuation possible at the time of conversion.

Terms and essential aspects of convertible loans

There will be several paragraphs handling things like interests, conversions, conversion discounts, and valuation caps in a convertible loan agreement. Please note that there can be special clauses in every convertible loan agreement, and therefore each founder must read them carefully.

Interest: A convertible loan can require interest on the granted amount; however, this is usually a so-called “payment in kind” interest where the startup is not paying cash, but the accrued interest amount is also converted into equity.

Conversion: This crucial part of the convertible loan agreement handles the conditions for converting the loan to equity. There will be one or a few events defined which trigger the conversion. The most common event is the following equity financing round. It often requires a “qualified” funding round that can be defined in various ways, like having a certain amount of new money coming in.

Conversion discount: It represents the discount on the startup’s valuation at which the loan is converted. The easiest way is to look at this example: An investor invests EUR 500.000 at a valuation of EUR 3.000.000. Without a discount, the investor would receive an equity share of 14%. Assuming that the investor gets a 20% discount, the considered valuation would be EUR 2.400.000, which would result in an equity share of 17%.

Valuation cap: As I mentioned above, the valuation cap protects the investor from receiving a relatively small equity share due to a high valuation. This cap is tied to certain expectations an investor might have when it comes to the startup’s performance. It also indicates what the investor perceives as a realistic value at the time of the conversion.

While there are obvious advantages of the convertible loan, founders must have a clear view on the loan mechanics and the resulting dilution for him and the investors. Each convertible loan agreement can have individual clauses, so make sure that you not only check the obvious points that will be in the contracts (valuation cap, conversion, discounts etc.) but also read everything in detail.