Between equity investments and convertible loans, the convertible loan is generally the less frequently used investment method. To begin with, let’s gain some understanding of both major methods of investing. Equity investments involve an investor who gives cash to receive a stake in a company in the form of shares or stocks. (shares/stock). On the other hand, the other method is the convertible loan which involves providing a loan to a company with a maturity date and interest. Even more, the investor retains the right to convert the loan into an equity stake in the company at some point in the future (discretionary conversion), or is forced to do so in the event certain terms are met (automatic, or mandatory conversion).
Being the road less traveled, we would focus our gaze on the basics of convertible loans and we would also cover the basics of a convertible loan agreement.
As we explained earlier, a convertible loan is a short-term debt that converts into equity. The lender has the option, and in some cases the obligation, to convert the loan in the next equity financing or in the event of an exit transaction (IPO/, particularly in the event of a sale of the company). This conversion usually takes place at the next investment round. A convertible loan can help because it is comparatively simpler, easy to agree and does not require to go through the motions of issuing shares.
Regardless of the case surrounding the conversion, the terms of the conversion are defined in the convertible loan agreement. A convertible Loan Agreement is signed by both parties, and contains the negotiated terms for borrowing agreed by those parties. Generally, it uses the price paid by the investor(s) in the next equity round as a reference point.
Key Terms In a Convertible Loan
Conversion: describes the conditions under which the loan is converted to equity.
Conversion Price: is the price that is used to calculate the number of shares issued to the lender in return for transferring the loan to the company. The conversion price is calculated by subtracting the agreed discount from the share price paid in the equity round or exit transaction where the conversion happens.
Conversion Cap: 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 higher.
Valuation Cap: refers to the maximum valuation at which the loan will convert.
Interest rate: This is the interest the startup shall pay on the loan. It is typically a PIK (payment in kind) interest.
Maturity date: This is the time by which the loan matures.
Pro-rata right: refers to the right to subscribe to new shares in proportion to an existing stake held.
Functions of Convertible Loans
Convertible Loans may be used:
As a source of ”bridge financing or funding” – before an anticipated large financing round.
At times when investors and entrepreneurs can’t agree on valuation, especially when they define a conversion discount but not necessarily the valuation cap.
At the seed stage.
Convertible loans are very useful but are also imperfect solutions for any type of funding situation. They are best used If there is a need to raise cash as quickly as possible without the stress involved in a full-stack seed financing, or if the committed investment amount is inadequate.
Investors should consider making a request for an express agreement on pro-rata and information rights, and should be careful when agreeing to lengthy (or non-existent) maturities.