Convertible loans, also known as convertible notes (or convertible debt), are a popular method of funding for startups. They function as a hybrid instrument combining features of both debt and equity. Here’s a breakdown of how convertible loans work for startups:
A convertible loan starts as a traditional loan (debt) with a set interest rate and repayment terms. However, unlike ordinary loans, the debt "converts" into equity (shares in the company) at a later date, usually during a future funding round (like a Series A) or at the maturity date of the debt, depending on the specific terms.
The key idea is that instead of requiring the repayment of principal and interest in cash, the loan converts into equity shares of the company.
Convertible loans are typically used by startups because they:
- Delay valuation: At the early stages, it's hard to put a valuation on a startup. Convertible notes defer the question of valuation until a future round where the startup might have more traction and a better basis for valuation.
- Speed up funding: Since valuation and complex negotiations are postponed, convertible loans allow startups to secure funding quickly.
- Attract investors: Early investors don’t need to negotiate an equity stake and can benefit from future discounts or better terms when their debt converts into equity.
Here are the main terms typically associated with convertible notes:
This is the amount of money being loaned to the startup by the investor. The company will use this money like any other form of capital funding.
Like any loan, a convertible loan typically accrues interest. This interest can be compounded annually and usually converts into equity alongside the principal. The interest rate is typically lower than that of regular loans (often in the range of 2%-8%).
This is the date by which the loan must either be repaid (if it hasn't converted into equity) or is converted into equity. The maturity date is typically set between 12-24 months from when the loan was issued.
The conversion event is usually the next equity funding round (e.g., Series A) when institutional or venture capital investors provide larger, equity-based investments. At this point, the convertible loan’s value (principal plus interest) converts into equity (shares).
A valuation cap benefits investors by setting a maximum valuation at which their loan can convert into equity. If the company’s valuation greatly increases by the next funding round, the valuation cap ensures that early investors can convert their loan into shares as if the company’s valuation was capped at a pre-agreed level. It’s a way for early investors to benefit financially from taking the early risk.
The discount rate is an incentive for early investors. When the note converts into equity, the investors receive shares at a discounted rate compared to the new investors in the funding round. For example, if the discount rate is 20% and the new investors are buying shares at $1 per share, the convertible note holders can buy shares at $0.80 per share.
Let’s assume an early-stage startup needs $500,000 in funding, but it’s too early to negotiate a precise valuation. An investor agrees to provide the funding as a convertible loan.
- Principal Amount: $500,000 loan from the investor.
- Interest Rate: 5% per year.
- Maturity: 18 months.
- Valuation Cap: $5 million.
- Discount Rate: 20%.
Within 12 months, the startup raises a Series A round of $3 million, with the new investors valuing the company at $10 million.
- The valuation cap kicks in, allowing the convertible loan investor to convert their loan as if the company’s valuation was only $5 million.
- Additionally, because of the 20% discount, the investor gets an even better deal when converting the debt to equity. So, the investor would end up with more shares than if they had waited to invest at the Series A valuation.
If the startup doesn’t raise another round by the maturity date (18 months), the agreement may force conversion of the debt into equity at an agreed valuation, or the company may need to repay the loan in cash. In some cases, investors allow extensions of the maturity date if they are confident in the company's progress.
- Simple and fast: Convertible loans allow startups to secure capital quickly and postpone more complicated valuation discussions to a later round.
- Lower risk for the investor: Investors can benefit from the upside (by converting into equity) but have some downside protection since it starts as debt, which can potentially be repaid.
- Delay in valuation: Early-stage companies often find it difficult to determine a valuation, so deferring it is beneficial.
- Maturity risk: If the startup is not able to raise a follow-on round before the maturity date, it may be forced to repay the loan in cash, which could hurt the company financially.
- Complexity if not managed well: Although deemed simpler than equity negotiations, the inclusion of varied clauses like valuation caps and discounts can still lead to complicated conversion processes.
- Dilution: Founders may have to give away a larger portion of their company than anticipated once the note converts to equity, especially if a valuation cap was used.
Convertible loans provide a flexible funding solution for both startups and investors. Startups benefit by delaying tricky valuation debates until later, while investors are rewarded for early participation through discounts and caps. However, founders must be mindful of terms like maturity dates, valuation caps, and interest rates to avoid potential downsides like large equity dilution or unsustainable debt obligations.