Startups require capital at various stages: when starting their business, for further growth, or between funding rounds. However, securing funding from venture capital is time-consuming and challenging. And it has become much more difficult.
In this case, a convertible loan can become a relevant option. Convertible loans are financial instruments that offer flexibility and benefits to investors and companies – without valuing the company. They are a hybrid form of financing that combines features of debt and equity, providing an innovative solution for raising capital, particularly for startups and growing businesses.
In this article, we will explain what convertible loans are, the essential role of company valuation, the different elements of a convertible loan contract, and what founders should consider beforehand.
A convertible loan, also known as a convertible note, is a type of short-term debt that converts into equity, typically in the form of shares, at a later stage, usually during a subsequent financing round. The conversion is usually triggered by a specific event, such as a predefined milestone or the next round of equity financing.
Imagine a startup in its early stage. It has minimal to no revenue, not yet achieved product-market fit, and an unproven business model, making its future challenging to evaluate.
Due to these uncertainties, the company's value cannot be precisely determined. Everything depends on positive outlooks for the future. Convincing venture capital fonds and business angels to invest in this situation can be a challenge.
Yet, the startup urgently needs capital. Its cash runway is only a few months. It requires bridging with fresh capital until the next financing round.
This is where a convertible loan as an alternative financing option comes into play. Convertible loans are loans through which startups receive debt capital – but with a particular feature.
A convertible loan grants lenders the right to convert debt into equity at a later date, typically during the next financing round.
Startups gain rapid access to capital, much faster than with other financing sources. They typically use a convertible loan for:
However, the quick access to capital comes at a certain cost of capital. Initially, startups take on debt that they theoretically need to repay. If debt is converted into equity, the investors acquire company shares at a significantly lower price than new investors. This leads to a higher dilution of company shares.
On the other hand, investors with a convertible loan engage in a certain risk mitigation. In the initial phase, they only provide debt capital with a fixed term, interest, and repayment rates. The risk is more manageable than with an equity investment. Debt capital can later be converted into equity, depending on whether the conversion was set as a right or obligation in the contract.
Months of analysis and negotiations with investors about a company's fair valuation? All of this is initially set aside when it comes to convertible loans.
The involved parties require only minimal information to make a decision. Convertible loans are often an instrument through which existing investors provide additional fresh capital. They are familiar with the startup and have already evaluated it closely during their initial investment.
When founders are in discussions with investors regarding financing, the company valuation plays a crucial role. The value of a share determines how many shares a company must give up (dilution) and the amount that investors will invest in the company.
In the case of convertible loans, this is not foreseen. Company valuation is not part of the negotiations. The involved parties await the next financing round, during which the lenders will base their valuation on the valuation determined at that time.
This speeds up the process and makes convertible loans a relatively quick-to-implement financial instrument.
Typically, it only takes two to five pages to draft a convertible loan agreement. In the case of a VC funding, it can involve up to 50 pages. This also positively affects the costs associated with drafting such contracts, as it doesn't require lawyers or notaries.
Such a convertible loan agreement includes:
In particular, the rules for conversion and investor rights are essential components of this contract. We will delve into each of these components in detail below.
Repayment at the end of the term? Interest-free period? Height of the conversion discount? Valuation Cap? All of these elements can be flexibly tailored to suit the needs of the parties involved. That makes convertible loans relatively flexible. The interests of startups and investors can quickly align.
The granting of million-euro amounts is rather rare with convertible loans, at least in the early stages of a startup. Funding amounts typically range from €100,000 to €500,000. Due to the uncomplicated nature of the contract, startups can also finance themselves with several convertible loans, each for smaller amounts. However, convertible loans are not only interesting for early-stage companies but also for startups in the growth phase.
A convertible loan is an alternative financing instrument, sitting between debt and equity. It represents a blend of both and, therefore, it’s characterized as mezzanine capital. Banks treat it as "equity-like", which positively impacts the company's creditworthiness.
As mentioned earlier, a convertible loan agreement can be drafted relatively quickly. Here are its key components:
Contains provisions related to loan disbursement, including:
Is the disbursement made all at once?
Is the disbursement made in tranches?
Are there any milestones attached to the disbursement?
The duration of a convertible loan is typically short, usually ranging from one to three years.
How high is the interest rate?
Is there a grace period?
How high is the repayment rate?
Is the repayment rate paid regularly (e.g., monthly) or at the end of the term?
Describes the conditions under which debt can be converted into equity or a company shareholding.
Key elements of the conversion include:
Investor rights outline the rights granted to investors, such as participation in decision-making, access to information, or other privileges like liquidation preferences (distribution of exit proceeds).
Convertible loans typically come with a qualified subordination clause. In the event of insolvency, the repayment claim of convertible loan lenders is placed at the very end of the list of creditors ("subordinated"). This is because investor claims are treated as equity, and thus not considered a liability of the company.
Several steps precede the conversion of debt to equity. These include:
To enter into a convertible loan agreement, a shareholder resolution is required. This typically requires a simple majority in the shareholders' meeting, usually composed of the founders (in the case of a startup).
With the approval of the shareholders' meeting, the convertible loan agreement can be executed. The startup receives capital, and the loan becomes effective. Companies can find a standard contract for this at the German Startups Association.
At the end of the contract term, investors have the right or obligation to convert their loans into company shares. A capital increase is necessary because the company must issue additional shares. Within the shareholders' meeting, this resolution requires a 75% approval.
After the capital increase, the former investors become shareholders of the startup. This is when the calculations for the valuation discount or valuation cap come into play. But what are the mechanisms behind those terms?
The valuation discount determines the discount that investors receive on the shares. This means that they pay less per share than new investors. This discount usually ranges between 20 to 30%.
The valuation cap is the maximum company valuation at which debt capital converts into equity. For example, if the convertible loan providers set the Valuation Cap at €5 million, but the startup is valued at €10 million in the next financing round, the convertible loan providers will convert at the predetermined valuation of €5 million.
However, the valuation discount and Valuation Cap typically do not apply together. The parties contractually agree in advance that the convertible loan providers must choose one of the two instruments at the time of conversion.
Initial situation: A startup founder holds all 100,000 company shares.
Initial situation: A startup founder holds all 100,000 company shares.
In this scenario, the valuation cap can serve as an incentive for investors to participate in a startup as early as possible and take on the additional risk.
Convertible loans offer a valuable financing solution for startups facing challenges in securing traditional VC funding. By transforming debt into equity, these loans provide rapid access to capital without the need for precise company valuations, making them particularly attractive for early-stage businesses.
Key aspects of convertible loans include their flexibility, quick execution, and relatively straightforward contract structures. They allow startups to bridge financing gaps between funding rounds and fuel their growth without the complexities associated with traditional equity investments.
However, while convertible loans offer benefits such as quick access to capital and low costs associated with contract drafting, they also come with potential drawbacks. These include the dilution of company shares and the risk of high discounts on future valuations for investors.
Overall, convertible loans represent a hybrid financing instrument that balances the interests of startups and investors, providing a valuable alternative to traditional funding methods.
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