Startup Financing 101: What are convertible loans?

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This post has been first released on YSB Balkans.

Finding adequate financing for your business is a challenge. Not only is it hard to find affordable investments. You also have to find investors that believe in you and your vision. And you have to find the right type of financing to fit your needs. This series on Startup Financing 101 explains how you choose the right type of financing for your business. This time, we explain how convertible loans work and when they are used.

What are Convertible Loans?

When investors talk about “convertibles”, they mean convertible loans. And they are what they sound like: Loans. They have an interest rate, a duration (“maturity”) and repayment terms. But convertible loans can also be converted into shares in your company (“equity”). That means that the outstanding money that you still owe to the investor (outstanding principal and accrued interest) can be converted into shares in your company.

When investors sign a convertible with you, it means the investor agrees to share the risk of failure with you. Convertible loans are treated as equity when your business goes bankruptcy. That means, that they usually default in 90% of the cases when a business goes belly up. If the business goes well, however, the investor is rewarded for taking that risk by choosing whether he wants to get his money plus interest back or convert the loan into shares in your company.

Example A (Basic Convertible Financing): So let’s assume that you have a convertible loan of 100 with investor A. Your business succeeds and the investor chooses to convert the loan into shares in your company. How many shares the investor gets depends on how you negotiate the contract. Let’s assume the contract says that the investor can convert the loan into shares at 2 per share and your business has 200 shares. That means, the investor gets 50 shares in your company or 25%.

There are different ways to set up “triggers” – events when the loan is converted. With startups that ultimately seek new financing from VCs or other institutional investors, the conversion is usually automatically triggered with the next funding round. For other companies, investors may reserve the sole right to trigger the conversion whenever they want (or not at all).

Example B (Startup Financing Rounds): You have a convertible loan with investor A of 100. A new investor (investor B) comes in, wants to provide another 100 and agrees that your business is worth 900 before he invests. That means your “pre-money valuation” is 900 and your “post-money valuation” is 1000 (900 + 100 from investor B). So after the investment, your business “is worth 1000”. Investor A will now convert the 100 outstanding loan into shares in your company. Because the valuation was 1000, that means investor A and B both get 10% of your company for the 100 they put in.

For a more advanced explanation see this blog post by Capshare.com. Note that this is simplified and does not include the interests linked to the loan. In practice, accrued interest for the loans is included in the conversion.

In which cases are Convertible Loans used?

At the early stages of a company, it is really difficult to determine how much the company is worth – or in other terms what the “valuation” of the company is. That means, that it is difficult for you and the investor to agree on whether the investor should get 5% of your company, 10% or 25% for the money that is invested.

But the process of registering new shareholders is quite complex. And you really want to avoid changing the number of shares per shareholder after you have registered them – just because it’s a pain in the a** from a legal and administrative perspective.

So it is simply easier to set up a convertible loan until you know how much your company is worth (based on the revenues that you will hopefully be making or based on the valuation the next investor is willing to accept). And it is also much quicker because it does not need to be registered with any local authorities (exceptions may apply for foreign investors).

What to watch out for

Interest Rate: As mentioned above, convertibles are designed to speed up the investment and avoid difficult discussions about valuation in the early days. But ultimately, they should be seen as a form of equity investment. That means that interest rates should be moderate and not exceed market standards. Interest payments are usually due on an annual, or at most quarterly basis. Depending on your country, you also want to avoid zero interest convertibles for tax reasons. Authorities may tax you on the fictional interest that could have been made.

Covenants: Covenants are conditions that come with the convertible loan note. Those covenants can create serious implications down the road. So you want to play through all the scenarios before accepting them.

Read more if you want to raise money from VCs

What we are describing here are the very basics of convertible loans. That is simply because we think these are the most important elements you have to know in the context of the Balkans. But if you are looking to close rounds with VC or other institutional investors after your first round with a convertible, you should really dive a bit deeper and read this blog post by Seedcamp or this one from Techcrunch.

Where can I find a legal template for a convertible loan?

There is a lean and quite simple template available from the SEC in the US. It gives you an overview of the elements of such a convertible loan note and its conditions. Of course, you want to consult your own lawyer that knows about specific local legal requirements.

About the Author

Daniel (@dannowack) has started four businesses in image manipulation, mobile payment, online marketing and publishing. He held various roles in startups such as CEO, CFO and Head of Business Development. He has a background in marketing and finance and has been involved in multiple 6- to 7-digit funding rounds in the past. He is a product and finance mentor for Google LaunchpadX. Daniel has been working with Prof. Yunus since 2010 and was in the driver’s seat for projects such as Social Business Cities or the Global Social Business Summit 2011. He currently heads YSB Balkans as Executive Director.

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