When founders are looking for investors and a quick cash injection for their startup or don’t know their initial valuation, they might want to get a convertible loan, which is a combination of a loan with favourable terms and an investment. A convertible loan enables investors to invest in a project that has great potential but a not particularly clear value. How exactly does it work?
A convertible loan agreement is a legal instrument (contract) entered into between an investor and a startup (or its founder). Under the agreement, the investor provides the startup with funds in exchange for the future right to convert those funds into shares or the option to have those funds repaid with interest.
If the conversion terms are not met and the investor has the funds repaid, it is essentially a classic loan, provided that the startup has the money to repay it. If the conversion terms are met, the real venture adventure begins.
What are the features of a convertible loan?
In a standard equity investment, the investor “exchanges” funds for an equity interest in the startup in the form of a controlling interest, future profits, or future proceeds from the sale of the startup upon exit. The funds are exchanged with equity immediately on the effective date of the relevant investment documentation. An equity investment is therefore suitable for startups with a known valuation, which makes it possible to derive the value of the investor’s share being acquired. An equity investment, as opposed to convertible investment, is mainly used in large qualifying rounds in which convertible loans that have already been provided are converted.
One of the significant advantages of a convertible loan over an equity investment is that it is faster and costs less.
As opposed to a standard equity investment, a convertible loan allows postponing the discussion about the startup’s valuation and the value of the investor’s share until the startup’s value can be determined in a relatively satisfactory manner. The advantage of delaying this moment is that neither the founder nor the investor has to discuss the valuation at that moment, as the investor might very likely think they are giving too much, and the founder might think they are getting too little. The convertible loan will therefore allow the financing of a startup directly without a known valuation. However, this does not mean that a convertible loan agreement does not determine any valuation whatsoever.
Faster and cheaper
One of the significant advantages of a convertible loan over an equity investment is that it takes less time and money. The loan can be taken relatively quickly, within a matter of weeks. The loan agreement is relatively short and is not preceded by comprehensive due diligence. In addition, it is relatively inexpensive to draft (with the costs usually not exceeding the lower tens of thousands of CZK). However, this may differ from the case where a convertible loan is used as operating financing between two qualifying rounds and is provided by an investor who is not yet part of the startup. Such an investor often requires more sophisticated legal due diligence and a more complex loan agreement.
Before drafting the convertible loan agreement, it is naturally a good idea to have a short term sheet containing the main commercial parameters. This saves both time and costs on both sides.
A convertible loan offers another major advantage for the investor, namely the option to have the money returned with interest and forget that there ever was any investment. However, investors putting too much emphasis on this right during negotiations are not very popular with founders. Such an approach shows that they don’t trust the startup much and prefer to have their money back with interest.
To convert or not to convert?
What is the procedure for settling a convertible loan? Is the investor free to choose between repayment and conversion? Should the investor have the right to choose between the two options? Or should the investor be obliged to convert if the terms for the conversion are fulfilled?
This is more of a philosophical question, but we are inclined to believe that the second option is the correct one. This means that the investor does not have the right to choose and must acquire an equity share in the startup once the conversion terms have been met. In our experience, we know that investors entering into such a loan relationship primarily wish to acquire an equity share in the startup, “monetising” their investment at exit, potentially up to ten times their initial investment.
So how and when does a convertible loan turn into a share and what is the procedure to calculate the startup value? The borrowed money is converted into equity shares in a “conversion event”. This typically happens in a qualified investment round, with the investor acquiring a share in the startup in exchange for the funds provided (equity investment), which usually takes place in a Series A investment round. In an equity investment, the valuation of the startup can be determined to calculate the post-money value of the investors’ shares from the convertible loan. Unlike a conventional loan, where interest may be paid on a regular basis, interest on a convertible loan accrues to the principal, becoming payable on the date of the conversion event.
Risk and discounts
The difference between an equity investment and a convertible loan is not only about the (deferred) acquisition of the equity share. Since convertible loans are typically used in early (pre-)seed investment rounds, such investors take on much more risk than investors in later investment rounds. The (pre-)seed investor can have the startup pay for the increased risk through a conversion discount and a valuation cap. A conversion discount gives the investor the right to buy a share in a startup at a certain discount to the price of a comparable stake achieved in a qualified investment round. The earlier investors invest in a startup, the higher the conversion discount they can get and the more aggressive the valuation cap, because they carry more risk.
The valuation cap allows the investor to cap the valuation of the startup at a certain amount. If the valuation is higher than the agreed valuation cap, the investor receives a higher share than they would have received if the convertible loan did not contain a valuation cap. This, among other things, protects the investor from a large dilution of their investment (a 0.002% share is of no use).
Investors also routinely push for MFN clauses. With an MFN clause in place, the investor is entitled to receive (any) benefit potentially granted in subsequent seed rounds that occur after the convertible loan is taken but before it is converted into shares.
Other scenarios
An investment from a convertible loan does not necessarily lead to conversion or repayment. There is one typical and very likely scenario – the startup goes out of business. This can happen for any reason, but most frequent cases include a decision to liquidate the company or to sell the startups’ assets and liabilities.
In such cases, it is not impossible for the investor to demand the return of their investment (i.e. the loan) plus interest even though we do not consider it standard. If there is anything left, the startup’s assets are sold off and the investor receives the surplus after the liabilities are settled. The founders usually receive nothing, or they give all the excess value up to the amount of the investment to the investor. Such a deal is called a liquidation preference.
Another situation, which is in our view even more unusual in the context of a convertible loan, includes something called a full ratchet provision. Full ratchet is designed to protect early investors’ shareholdings from dilution in later investment rounds. To put it simply, it works like this: the company internally estimates its value, and if the value falls in subsequent investment rounds, the founders make up the difference to the investor against the lower valuation. Startups with the investors’ full ratchet rights may be harder to invest in the long term and founders run the risk of having to give up too high a share, which in turn has a negative effect on their long-term motivation.
Conventional or convertible loan
We have discussed what a convertible loan is and what you should focus on when negotiating one. But wouldn’t it be better to take out a standard loan with interest without having to worry about conversion? A startup usually doesn’t get a conventional loan from anyone (especially a bank). The main reason is that loan financing provided by banks is covered by a standard form of collateral (bank guarantee, security rights, promissory notes, etc.), which startups and founders are most likely not able to provide.
However, something called bridge financing can be seen, which is used to bridge the end of one investment round (when the startup runs out of money) and the beginning of the investment round immediately following (such as seed – series A). A specific feature of bridge financing is that it is usually provided by existing lenders. After the startup receives funding in the following investment round, it repays the bridge loan and moves on. Bridge financing is often provided in the form of a convertible loan.
