Convertible Loans: What to Look out For

It probably happens to most founders at least once: His or her company needs money quickly and there is an interested investor, but there is not enough time to execute a full-stack seed financing including governance rules, exit provisions, etc. Or even when there is time, the committed investment amount may not yet be sufficient. Or there is confidence that a small bridge funding will be sufficient to raise a proper financing round at a (much) higher valuation shortly thereafter. Or you just want to keep it simple…

In these cases, a convertible loan can help because it’s comparatively easy to agree and does not require to go through the motions of issuing shares. If you’re new to the topic, a convertible is a loan (i.e. debt) by name, but due to the conversion option, it’s actually closer to equity. Put simply, the lender is given the option (sometimes also the obligation) to convert the loan in the next equity financing or in the event of an exit transaction (in particular a sale of the company). In both cases the terms of the conversion, in particular the conversion price (i.e. the price that is used to calculate the number of shares issued to the lender in return for transferring the loan to the company), are defined in the loan agreement, generally using the price paid by the (cash) investors in the next equity round as a reference point.

While these basic mechanics are clear and straightforward, there are certain aspects that both the company as borrower and the investor(s) as lender(s) should keep in mind when discussing the fine print, three of which I’ll take a closer look at below: The computation of the conversion price (below 1), pro-rata and information rights (below 2) and governance (below 3).

1. Conversion Price

When talking about conversion of a convertible one generally hears two buzzwords: “discount” and “cap”. A discount is comparatively easy to do: The conversion price is calculated by subtracting the agreed discount (if there is one) from the share price paid in the equity round or exit transaction where the conversion happens.

With cap the convertible lingo generally means a maximum conversion price that will apply even if the share price in the equity round (after deduction of any applicable discount) is (a lot) higher. When agreeing the cap the easiest would obviously be to use a share price, e.g. “EUR 10 per share”, but since nobody knows how many shares, options, warrants, other convertibles, etc. there will be at the time of conversion, a certain price per share agreed today could lead to a wide range of valuations in the future. For an investor this kind of uncertainty is hard to accept, especially given that he or she does not have much control over the business until conversion (more on this below).

It is therefore common to refer to a valuation of the entire business, not to a price per share, when defining the cap. If this value is defined as “post-money” (which, based on our experience, is still rare for normal convertibles, but has, after a recent change, been incorporated in the standard “Simple Agreement for Future Equity (SAFE)” often used in the US instead of a traditional convertible), it will give the investor (lender) certainty about the (percent) size of his or her stake at conversion: If, say, the investor invests EUR 1 million at a post-money cap of EUR 10 million, he or she knows that, prior to the dilution caused by the shares issued for cash in the funding round, his or her stake will be at least 10% (= EUR 1 million/EUR 10 million). Technically this is done by including the shares issued to all other convertible investors in the definition of “fully diluted shares” that are used to calculate the conversion price.

While this approach is advantageous from the investor’s perspective, it’s risky for the founders. A post-money valuation of EUR 10 million may sound great if the company only issues EUR 1 million in convertibles before the proper funding round, but what if the funding (which may require a certain minimum volume to trigger the conversion) takes longer to materialize and the company needs further interim financing? If in this case the company issues another EUR 2 million of convertibles, the (guaranteed) stake of the first investor will remain at 10% despite the fact that the business’ value has just gone up by EUR 2 million (because of the additional EUR 2 million of cash in the bank). In other words, assuming the additional convertibles are issued at the same terms, the effective pre-money valuation of the company has just decreased from EUR 9 million to EUR 7 million (= EUR 10 million — EUR 3 million convertibles). A conversion price that initially would have been EUR 9 per share (assuming one million fully diluted shares prior to the conversion) is now only EUR 7 per share, and the founders are diluted by 30% rather than 3/(9+3)= 25%.

Here is a direct comparison of what’s going on (always assuming the valuation of the company in the funding round which triggers the conversion is higher than the cap, i.e. the cap determines the conversion price):

The consequences of the post-money approach, i.e. the lender’s stake remaining the same even if the company issues additional convertibles, may be fair IF the delayed financing is the result of a poorer than expected development of the business, but there may be other reasons at play, e.g. a successful product pivot that would allow the company to change plans and skip the seed round and directly raise a Series A. In this case, the founders will face the awkward choice between an unnecessarily early seed round in order to trigger the convertible conversion or the greater dilution if they do another convertible instead in order to raise a Series A shortly thereafter.

The aforementioned concerns do not mean that a post-money cap should be avoided under any circumstances. In fact, it may make sense if the relevant investor (lender) is willing to offer a premium in return for the certainty on the size of his or her stake at conversion. BUT in this case the founders should be confident about the later funding round which triggers the conversion. If there is doubt, in particular if the equity funding requires a minimum size, founders may be better off pushing for a pre-money cap. In this case, the later convertibles, just like the initial one, will not be included in the fully diluted capital so that the initial lender is diluted by the further convertibles as if he or she had provided “real” equity instead of the convertible.*

2. Pro-rata rights and information rights

The pro-rata right, i.e. the right to subscribe to new shares in proportion to an existing stake held, is one of the most important investor rights. It not only helps the investor to increase his or her exposure if things go well after the initial investment, and to avoid massive dilution in case of a down round, but can also be important to maintain certain rights that are linked to a minimum percentage shareholding (e.g. information rights or the pro-rata right itself).

While all this is straightforward and uncontroversial where the investor holds “real” shares, it is much less so if the investor merely has an option to subscribe for shares in the future (as is the case with a convertible loan or, for instance, a warrant). There generally is no principle of corporate law that entitles a convertible lender (or a warrant holder) to subscribe to additional shares (i.e. on top of the conversion shares) if and when the company issues shares (or other equity-like instruments), irrespective of whether the convertible is converted at that time or not, and accordingly pro-rata rights are much less common in convertible loan agreements than in regular shareholder agreements.

Still, a convertible investor has a point when demanding to be treated as if he or she already held the shares the convertible will ultimately convert into (in which case a pro-rata right would not be controversial). Recognizing this, pro-rata rights have become increasingly common also in convertible agreements over the past years based on our experience.

Similar to pro-rata rights, which as we have seen are not standard, but in our view should generally be accepted if requested, information rights are normally not part of standard convertible loan templates, but mostly uncontroversial if requested by the lender. The rationale is similar to the pro-rata right: There is no good reason why a convertible lender should not be informed about the affairs of the company as if he or she already held the conversion shares. Based on our experience it is, therefore, increasingly common to add a side letter or twin clauses to the loan agreement providing for both the pro-rata and the information right.

3. Governance

The lack of governance rights, in particular the express enumeration of measures which in a standard equity round would be agreed to require investor approval (often referred to as reserved matters), is probably the most underestimated implication of a standard convertible. There are (close to) no governance rights to speak of that allow the convertible holders (who have invested in a convertible without having been shareholders of the company already) to influence the company. Of course such rights could be expressly agreed by the parties. However, this is, based on our experience, extremely rare, as the investor (lender) is not officially on the cap table yet, his or her (future) stake uncertain and agreeing on the relevant matters potentially time-consuming.

The lack of governance (in case the convertible is used as an initial funding without any reserved matters already in place) is therefore seen by most convertible investors as a necessary evil which they accept either to get a foot in the door in a competitive funding situation or where there is sufficient trust in the founders not to “mess things up” before the loan is converted. All of this is obviously subject to a reasonably short period until the investor can demand repayment or conversion (in case there is no equity funding). Convertible investors who aren’t shareholders yet therefore generally demand a relatively short maturity of 6 to 12, in rare cases also 18 months.

There is one notable exception to this rule: The standard US SAFE form does not have any maturity (which is also why it’s not called a loan). SAFE holders therefore cannot demand conversion (or repayment) as long as there is no equity financing or sale of the company. On the other hand, the recent change towards a post-money cap helps the investors in this respect as it makes continued funding with SAFEs/convertibles more dilutive for the founders (see above).

So…

…as with many things in life, convertible loans are neither the perfect solution for any type of funding situation nor a trap to stay away from out of principle. If there is a need to raise cash fast (or significant competition for a “hot” start-up), a convertible can definitely be the instrument of choice IF properly tailored** to the situation. In particular:

• Founders should be careful when agreeing to post-money caps
• Investors may want to request an express agreement on pro-rata and information rights, and
• Investors should be careful when agreeing to lengthy (or non-existent) maturities (unless they have governance rights already)

*) Note that there is one more aspect to keep in mind when looking at conversion prices and dilution, which is the employee incentive pool. While it’s standard to include all employee options issued or authorized prior to the equity round in the fully diluted capital, there are different approaches regarding a potential pool expansion agreed in connection with the funding round. Such an expansion is normally (also) included in the fully diluted capital in a typical convertible, but has been excluded in the recent update of the YC SAFE, somewhat offsetting the additional dilution risk for founders implied by the change to a post-money valuation.

• *) A proper contract management tool such as the one offered by our portfolio company Juro may be of great help in this respect, especially if there are many parties to coordinate.