What is a convertible loan?
Convertible Loan — is a financial instrument typically used for investments in early-stage companies and startups. However, many entrepreneurs still don’t know what it is and how it works.
In the article below I summarized some basic information about Convertible loans.
A VC fund or an angel investor usually invests in early-stage companies via a convertible note and 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, then 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 that 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 takes place before the deadline date. 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 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 here is agreeing on the valuation cap and discount rate.
When a convertible loan is used?
At early stages it is difficult to set valuation of the company, while issuing common stock might be more expensive than the total amount of the round itself.
Convertible loan mechanism allows entrepreneurs to focus more on operations and running the company and generating returns for the investors, without wasting valuable time on negotiations around valuation, etc.
In order to raise a bridge round before proper equity round. A company needs to reach certain traction and milestones via raising a small bridge in the amount of $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 Convertible loan
The structure of a typical Convertible Loan consists of three major parts:
1. 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 the means by which the loan can be repaid. 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 loan into equity upon raising a Qualified Financing Round (QFR — shall be defined separately). QFR means, that, for example, the company has to raise minimum amount of financing of $X mln within stated period of time (X months) at a pre-defined valuation cap and discount rate.
- Optional Conversion from loan into equity upon raising a Non-Qualified Financing Round — meaning the company raises less than minimum required threshold. The terms of conversion stay the same as within 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:
- The company has to repay the loan with interest accrued.
- Auto-conversion into equity takes place with predefined conditions. Participants agree on binding metrics of the business (Revenue, Income, etc.).
- In some cases, loan extension takes place with or without newly specified conditions.
How it works in practice?
For simplicity’s sake, let’s take a virtual company SuperCo with 1,000,000 shares, which initially belong to founders. Latter agreed to raise financing from early-stage investors (EarlyInvestor) in the amount of $1,000,000 via a convertible loan at $10M cap with 20% discount and 2.7% interest annually.
SuperCo, being a great company, attracts another investor (SuperInvestor) later on for a so-called Qualified Financing Round (QFR). From now on, there might be 2 possible scenarios:
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, EarlyInvestor is rewarded with 20% discount and gets $4 price per share within this round. SuperInvestor gets 400,000 shares ($5 each), while EarlyInvestor 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%, SuperInvestor gets ~24% and EarlyInvestor enjoys ownership of ~15%. Apparently, if there were no early-stage investors involved, SuperInvestor would have bigger stake. In this case it would go as following: 1,000,000 + 400,000 = 1,400,000 shares, which grants founders with ~71% and SuperInvestor with ~29%.
2. In the second scenario, let’s imagine there’s another virtual BullishInvestor who invests $5,000,000 at $20,000,000 pre-money — which is higher than valuation cap. In this case, BullishInvestor 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 EarlyInvestor is $10,000,000, then EarlyInvestor gets 100,000 shares ($10 each). Summing up shares 1,000,000 + 250,000 + 100,000 = 1,350,000, we can calculate shares of the parties. The founders get ~74%, BullishInvestor will have ~18.5% and EarlyInvestor gets ~7.5%.
As a sum up, this is roughly how convertible loans work. Having said that, in reality there are multiple nuances, which every entrepreneur needs to pay attention to. I recommend analyzing every document carefully in order 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 both convertible loans and invest as part of qualified financing rounds.
We hope this article was helpful to you. We are super keen to hear your comments, feedback or any questions regarding startups financing mechanisms.
Do you run an innovative tech startup? We are investing in early-stage revenue-generating software startups across the world and would love to hear from you! You can reach us at leta.vc
