Convertible Loan / Bond
The “Middle Ground” Between Debt and Equity Fundraising
Convertible Loans are a popular way for early-stage companies and startups to raise funds for their business. During 2018, the amount raised via Convertible Loans was over $50 Billion.
But what is a Convertible Loan and is it the right choice to support your U.S. market entry? In this guide, we’ll take a look at the main features of a Convertible Loan and the pros and cons of choosing this type of funding.
What Is a Convertible Loan / Convertible Debt?
A Convertible Loan, also known as Convertible Debt or a Convertible Note is a form of financing for your business that utilizes a loan that can be converted at a later date into equity in your business. Many entrepreneurs view it as a middle ground between selling equity and purely debt financing.
Investors loan you money that must be paid back with interest, however, the amount can be converted into equity when an agreed-upon “Trigger Event” occurs. Normally this event would be a further round of funding.
It is short-term debt, generally lasting for around 1 year to 18 months, at which point the loan should be paid back or the amount converted into equity. For this reason, it’s a popular option for young startups and businesses in early-stage growth.
The amount of money you can raise via a Convertible Loan can vary depending on your needs and investors, but generally speaking, amounts raised tend to be around $500,000 to $1,250,000.
Why Would You Choose to Raise Funds via a Convertible Loan?
One of the most attractive features about a Convertible Loan is that they allow you to seek investors without having to place a valuation on the company. This is great for young and emerging businesses who are not able to accurately value their company which makes it extremely difficult to secure equity-financing. In addition, it also helps to avoid issues that may arise when raising funds from rounds such as a Friends & Family round and not correctly valuing the company.
A Convertible Loan is often therefore used as a “bridging loan” enabling startups to grow before seeking a further round of funding. At this stage, a business has theoretically grown enough and has enough data to place an accurate value on the company. The “Trigger Event” in the form of another round of funding takes place and the loan is converted into equity.
Who Lends You the Money?
Businesses typically get Convertible Loans from early round private investors such as Angel Investors or Venture Capitalists. These kinds of investors are willing to take a risk on an early venture because there is a potential for high yields. A Convertible Loan is offered in the form of a discount on equity which is a preferential interest rate that compensates early investors for the risk they have taken by investing in a company at an early stage.
Many investors are also attracted by the speed and ease of a Convertible Loan, which can be completed quickly while avoiding high legal fees. In addition, a Convertible Loan does not come with the requirement of being a stockholder and with it the additional responsibilities. For some investors, this is a positive option because they do not want to be involved in management decisions. A Convertible Loan can also be attractive in terms of risk – if at the end of the term the business cannot be converted into equity then the debt is still payable.
What Are the Main Features of a Convertible Loan?
A Convertible Loan is a debt instrument that converts at an agreed upon time. One of its main aims is to help a business to grow, acting as a bridging loan, until the next round of funding is obtained by the business.
An interest rate on the principle of the loan is agreed upon. When the loan converts this interest and the principle are converted to equity in the company.
A Discount Rate and a Trigger Event are also chosen. The Discount Rate is the discount that the investor gets on the share price when its time to convert the loan. The Discount Rate or “Conversion Discount” works by offering investors a discount on the valuation of the shares when they are sold via a Series A funding round.
The Trigger Event is agreed under the terms of the conversion. This feature specifies the conditions under which the loan will be converted. It is rare for the investor to be able to choose to convert at any time they want to, instead, the conversion usually happens once “qualifying financing” is obtained – a minimum amount the company must raise before the loan is triggered to conversion.
When the loan converts the investor gets the principle and interest on the loan as equity and the shares they receive are also acquired at the agreed upon Discount Rate. Typically, the Discount Rate is between 10-30%, with 20% being the most common.
At a 20% discount rate, if shares are sold in the new funding round at $2 per share, then the investor receives shares at $1.60 per share. The principle and the interest accrued combine with this discount to determine how many shares they will receive in this new round of funding based on the amount they invested in the Convertible Loan.
Valuation Cap
Another important feature of a Convertible Loan is the “Valuation Cap.” The Valuation Cap is the highest amount that a business can be valued for the purposes of the conversion of the loan. Although the business can be valued at a higher rate during the next round of funding, the agreed upon cap limits the maximum amount of each share for the investor.
The Valuation Cap prevents early investors from losing out if the value of the business becomes too high during subsequent funding rounds. So, for example, if a business is valued at $5,000,000 during a subsequent round of funding, but the Valuation Cap is $4,500,000 the equity would convert at the lower amount.
Is a Convertible Loan Right for You? Pros & Cons of Convertible Loans
Convertible Loans, in common with other methods of fundraising, have advantages and disadvantages. Below let’s take a brief look at some of the main pros and cons of Convertible Loans.
Pros:
A Convertible loan is a widely-known and accepted method of fundraising. It’s quicker and less complicated than stock offerings which makes it attractive for many investors.
Transaction costs of a Convertible Loan tend to be low and legal fees are also low for investors and for entrepreneurs – it can cost between $1,000-$7,500 for a lawyer to create a Convertible Loan Note.
Because Convertible Loans are technically a form of debt that converts you don’t need to issue common stock or create a second class of shares – this helps to avoid complications and tax implications
Gaining investment from a Convertible Loan buys you time to delay valuing your company if it’s not ready to be valued yet.
Investors may have more incentive to support your company to grow. This is because if an investor is only investing in equity they may have a vested interest in limiting company growth in order to maximize the percentage of what they own in the company.
Convertible Loans are useful for businesses that do not have great credit or a long credit history and are unable to get loans from more traditional sources such as banks.
Cons:
Making a Convertible Loan too large could negatively impact future funding rounds as it could crowd out investors at the next stage.
If the loan doesn’t convert, you still have to pay the debt and the interest back – which could leave you and your IP at risk. This can be an issue because maturity times tend to be relatively short.
Some investors are averse to this kind of fundraising because they don’t want to forego shareholder rights such as voting rights, control rights and pro-rata rights.
What Is the Difference Between a Safe and a Convertible Loan?
Another instrument for raising funds that have similar characteristics to a Convertible Loan is a “Simple Agreement for Future Equity” (SAFE). A SAFE also raises funds by allowing for future conversion into equity, but unlike a Conversion Loan, it is not a loan. Therefore there is no interest and it does not have a maturity date.
However, a SAFE does not always have a specific Trigger Event, it gets converted at the next funding round and whenever a business raises more equity investment funds a SAFE can be converted.
The lack of a maturity date can be attractive to some entrepreneurs because this means that there is no specific time when the principle must be paid back or the amount be converted into equity. A SAFE requires that a company is incorporated and tend to be higher risk because without a maturity date there is no guarantee that future equity or debt repayment will be available.
Although SAFE’s are being used by some investors and entrepreneurs, Convertible Loans remain a more popular option.
How Mount Bonnell Advisors Can Help
A Convertible Loan is a debt instrument that converts at an agreed upon time. One of its main aims is to help a business to grow, acting as a bridging loan, until the next round of funding is obtained by the business.
An interest rate on the principle of the loan is agreed upon. When the loan converts this interest and the principle are converted to equity in the company.
A Discount Rate and a Trigger Event are also chosen. The Discount Rate is the discount that the investor gets on the share price when its time to convert the loan. The Discount Rate or “Conversion Discount” works by offering investors a discount on the valuation of the shares when they are sold via a Series A funding round.
The Trigger Event is agreed under the terms of the conversion. This feature specifies the conditions under which the loan will be converted. It is rare for the investor to be able to choose to convert at any time they want to, instead, the conversion usually happens once “qualifying financing” is obtained – a minimum amount the company must raise before the loan is triggered to conversion.
When the loan converts the investor gets the principle and interest on the loan as equity and the shares they receive are also acquired at the agreed upon Discount Rate. Typically, the Discount Rate is between 10-30%, with 20% being the most common.
At a 20% discount rate, if shares are sold in the new funding round at $2 per share, then the investor receives shares at $1.60 per share. The principle and the interest accrued combine with this discount to determine how many shares they will receive in this new round of funding based on the amount they invested in the Convertible Loan.
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