Decoding Convertible Loans: An In-Depth Exploration

Alina Gegamova
Leta Capital
Published in
6 min readNov 2, 2023

Convertible Loan is a financial instrument typically used for investments in early-stage startups. However, many entrepreneurs still have questions about this tool and how it works.

In the article below, our Senior Investment Analyst Anton, summarized some basic information about Convertible loans.

Convertible Loans in a Nutshell

A VC fund or an angel investor usually invests in early-stage companies via a convertible note. When a company raises the next round, investors convert that note into equity. In most cases, the conversion happens at a discounted valuation (valuation for early investors is less than for new investors) or with a predefined valuation (Cap) which is less than in the next funding round. It serves as a reward for the early investor.

Definition of the terms:

Discount Rate — establishes how much an investor is compensated for the additional risk he or she takes by investing in a company early on. For example, if a price per share is $5, a 20% discount gives an investor a $4 price per share upon conversion.

The Valuation Cap is another way to reward seed stage investors for taking on additional risk. The valuation cap sets the maximum price the loan will convert into equity. For instance, if the valuation cap is $10M and the new investor evaluates the company at $15M, the convertible loan of early-stage investors will be converted at a $10M valuation.

Interest — the convertible loan is a debt mechanism, hence, an interest is established as a yearly percentage of the loan body.

Maturity date — determines the deadline for the loan to be automatically converted into equity in case no funding round occurs before the deadline. Alternatively, an entrepreneur needs to repay it on previously agreed terms.

Benefits of Convertible Loan

  • Convertible loan financing tends to be faster than priced rounds. There is no need to create a second class of shares or issue common stock.
  • Convertible loan financing tends to be cheaper than priced rounds. Whereas the convertible note costs $2–5k, the cost of a Series A round can reach $10–30k or more.
  • Convertible loan financing tends to be simpler than priced rounds. This prevents a number of complications, including those arising from company valuations, stock option grants, and related tax implications.

N.B. The only time-consuming part is agreeing on the valuation cap and discount rate.

When a convertible loan is used?

At the early stages, it is difficult to set the company's valuation, while issuing common stock might be more expensive than the total amount of the round itself.

The convertible loan mechanism allows entrepreneurs to focus more on operations, running the company, and generating returns for the investors without wasting valuable time on negotiations around valuation, etc.

A convertible loan is used while raising a bridge round before the proper equity round. A company needs to reach certain traction and milestones by raising a small bridge for $300–500k. In this case, the convertible loan might become an admirable opportunity to get that bridge quickly and the investor can get on board without additional hassle.

The structure of a Convertible loan

The structure of a typical Convertible Loan consists of three major parts:

1. The definition of terms is set in the first part, as well as an investment amount, interest rate and maturity date.

2. Repayment terms are specified in the second part, and how the loan can be repaid. The following are the most common repayment mechanisms:

  • Cash and cash equivalent repayment upon investor request with no equity granted to an investor. Repayment includes loan body and interests accrued.
  • Cash and cash equivalent repayment upon founders’ request with no equity granted to an investor.
  • No cash repayment specified. Convertible loan cannot be repaid with cash and cash equivalents.

3. Conversion terms are stated in the third part and include the following elements:

  • Automatic Conversion from a loan into equity upon raising a Qualified Financing Round (QFR — shall be defined separately). QFR means that, for example, the company has to raise a minimum amount of financing of $X mln within the stated period of time (X months) at a pre-defined valuation cap and discount rate.
  • Optional Conversion from a loan into equity upon raising a Non-Qualified Financing Round — meaning the company raises less than the minimum required threshold. The terms of conversion stay the same as within the Qualified Financing Round, but the investor makes a decision regarding conversion separately.

If the company fails to raise any new financing before the maturity date, then there can be several outcomes:

  1. The company has to repay the loan with interest accrued.
  2. Auto-conversion into equity takes place with predefined conditions. Participants agree on binding metrics of the business (Revenue, Income, etc.).
  3. In some cases, loan extension takes place with or without newly specified conditions.

How does it work in practice?

For simplicity’s sake, let’s take a virtual company GREATco with 1,000,000 shares, which initially belong to founders. They agreed to raise financing from early-stage investors (EarlyVC) of $1,000,000 via a convertible loan at a $10M cap with a 20% discount and 2.7% interest annually.

GREATco, being a great company, attracts another investor (SuperVC) later on for a so-called Qualified Financing Round (QFR). From now on, there might be 2 possible scenarios.

The first scenario:

1. Given $2,000,000 investment at a pre-money valuation of $5,000,000 (meaning $5 price per share = $5M/1M shares). In this case, EarlyVC is rewarded with a 20% discount and gets a $4 price per share within this round. SuperVC gets 400,000 shares ($5 each), while EarlyVC gets 250,000 shares ($4 each=$1M/250,000).

($1,000,000)*(1+0.027)^(year = 0)/($5*0.8) = 250,000

Summing up all shares, we can calculate equity shares for each party. 1,000,000 + 400,000 + 250,000 = 1,650,000 shares, which means founders get~61%, SuperVC gets ~24% and EarlyVC enjoys ownership of ~15%. Apparently, if there were no early-stage investors involved, SuperVC would have a bigger stake. In this case, it would go as follows: 1,000,000 + 400,000 = 1,400,000 shares, which grants founders with ~71% and SuperInvestor with ~29%.

The second scenario:

2. Let’s imagine there’s another virtual BullishVC who invests $5,000,000 at $20,000,000 pre-money — which is higher than the valuation cap. In this case, BullishVC will get 250,000 shares ($20 each) ($20,000,000/1,000,000 = $20, $5,000,000/$20 = 250,000 shares). As long as pre-set valuation cap for EarlyVC is $10,000,000, then EarlyVC gets 100,000 shares ($10 each). Summing up shares 1,000,000 + 250,000 + 100,000 = 1,350,000, we can calculate the parties' shares. The founders will get ~74%, BullishVC will have ~18.5% and EarlyVC will get ~7.5%.

This is roughly how convertible loans work. Having said that, in reality, there are multiple nuances which every entrepreneur needs to pay attention to. Every founder should analyze each document carefully to prevent misunderstandings and disappointing conversion events.

You can follow the link below to use our simplified Convertible loan calculator:

At Leta Capital, when investing in Seed and Series A startups, we utilize convertible loans and invest as part of qualified financing rounds. Do you run an innovative tech startup? We are investing in early-stage revenue-generating software startups and would love to hear from you! You can reach us at info@leta.vc or fill in the form here.

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Alina Gegamova
Leta Capital

Head of Communications @ LETA Capital, early-stage VC firm