WHAT ARE CONVERTIBLE LOANS?
When startups want to raise money in order to grow, they can choose between two different options: equity financing or a convertible loan.
What are convertible loans?
A convertible loan is a short-term debt that can or will, at a defined point in the future, be converted into shares of the company. For example, if you receive your seed investment in the form of a convertible loan, it will convert to equity when you raise your Series A investment.
What is the difference between convertible loans and equity?
In an equity investment, an investor receives a stake in the company in exchange for cash. If the investor provides a convertible loan instead, he will provide a loan with a maturity date, interest and a special twist: the right to convert the loan into an equity stake in the company at some point in the future.
Is a convertible loan the right type of investment for my startup?
The advantage from the perspective of an entrepreneur 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 fairly short and simple document, it also gets executed faster (that’s why convertible loan investment can be processed faster than equity investment, typically by a couple of weeks).
Other important terms
“Interest”: Usually the convertible loan also carries interest, that will accrue from the date of the investment until the conversion date.
“Qualified Financing”: The size of the financing round that will trigger the conversion is set with a minimum amount. 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.
“Maturity date”: This date determines the deadline when the loan can 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.
“Trade sale”: This clause considers the possibility of the startup being bought before a qualified financing round takes place or the maturity date is reached. A trade sale usually also results in mandatory conversion of the loan into shares.
“Accession to shareholders’ agreement”: Investors, prior to receiving converted shares, have to accede to the shareholders’ agreement that is in force at the time of the conversion.
“Valuation cap”: It is in the interest of the convertible loan holders that the company valuation at the time of conversion is not excessive and that it reflects the risk they took by investing at an earlier stage. Therefore, a maximum valuation at which the conversion takes place can be put in place. This does not mean that the valuation in the next financing round cannot be higher or lower, it only defines an upper ceiling of what convertible loan holders will actually pay for their shares.
You can download our Convertible Loan Agreement HERE