There are two essential ways for a business to get cash in the door: the first is to issue equity (i.e. shares for cash), and the second is to raise debt from a lender (i.e. cash that needs to be repaid).
This post is focused on the second of these options and specifically the convertible loan.
What is a convertible loan?
Short answer | A short-term debt that converts into equity at a future date. |
Longer answer | A convertible loan has all the features you’d expect to see in a standard loan:
Unlike a normal loan however, it has a “convertible” element, so called because the lender has the right to convert the amount of the loan into an equity stake in the company at some point in the future (usually the next investment round). |
Advantages/Disadvantages for an Entrepreneur
Advantages
The lender investor doesn’t have many rights that a holder of preferred shares would have (i.e. board seats, liquidation preferences etc.)
Shorter document that can therefore usually be agreed and executed (with cash in the door) much quicker than a typical equity investment
Interest on the convertible loan isn’t normally paid out by the borrower, instead it accrues on the principal and gets rolled up into the equity conversion
E.g. if you raise a EUR 200,000 convertible loan with a 5% interest that gets converted into equity in 12 months, the actual amount that gets converted is EUR 210,000
Allows you to postpone conversations regarding valuation (subject to the Valuation Cap point discussed below).
Disadvantages
Until the loan converts, the investor has a priority right at the maturity of the loan to claim any assets that the company has to have the loan and any accrued interest repaid. Unless some additional source of financing can be found, then this usually results in a forced liquidation.
Not available for EIS/SEIS in the UK like an Advanced Subscription Agreement (see our article on ASAs here).
Terms that you will find in a convertible
Conversion: this clause is the core of the agreement and describes the conditions under which the loan is converted to equity. The standard conversion scenario is upon a “qualifying financing”: once a startup raises more than GBP 1,000,000 (or other realistic number) (i.e. raises a “Qualifying Financing Round”), the loan amount gets automatically converted into equity by reference to the price per share that investors received in the Qualifying Financing Round.
Conversion Discount: investors will normally expect to be compensated for taking additional risk and giving your company money at an earlier stage. This typically takes the form of a conversion discount to the price per share paid by new investors in the Qualifying Financing Round.
E.g. new investors invest at a valuation of GBP 10,000,000. If the convertible loan has a 20% valuation discount, the holder will convert the loan (+ accrued interest) to equity at a valuation of 10,000,000 * 80% = GBP 8,000,000.
20% is the most common discount we see, with a max of 30%.
Valuation Cap: this is the maximum valuation at which the loan will convert. This term protects the lenders in the scenario that the startup is more successful than was anticipated and increases significantly in value between the date the convertible loan was made and the maturity date.
Using the e.g. above, the investor might look to include a valuation cap of GBP 7,000,000. Without the cap, the investor would convert at a valuation of GBP 8,000,000, but with it the investor converts at GBP 7,000,000, which is a cool 30% discount to the valuation at which the new investors get in.
Founders may want to push back on the valuation cap being too low: not only will it be dilute to the founders, but new investors won’t love the fact that they are paying such a high relative premium.
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