What is a convertible loan and how do they work
Introduction
Going from being an employee my whole professional career to cofounding TheGoodPsy in 2020 meant transitioning from focusing solely on the responsibilities directly pegged to my software engineering role to a whole slew of business concepts I needed to get acquainted with. In Spanish we have the expression Por la cuenta que me trae, which could roughly be translated to because now you account for them.
Although still focused primarily on designing and implementing the technical roadmap and strategy for our digital product, I've had to make an effort into grasping concepts from marketing, accounting, or startup valuations.
At some point in TheGoodPsy's journey, there was a need for raising money to continue growing. I was rapidly introduced to concepts within the VC/Private Equity space such as equity, SAFEs, DCF, Convertible Loans, etc.
While I am by no means an expert on these notions, I've decided to take an approach I like a lot to consolidate my learnings which is to write about them in the blog to reinforce them.
I wanted to start with the concept of Convertible Loans.
What is a Convertible Loan
A convertible loan is a form of credit that can eventually be converted into equity, normally at a discount for the investors. When the maturity date of the loan is due, the creditors can choose whether to get the principal of the loan plus the interest repaid or convert it into equity.
This means that when an investor provides the startup money in the form of a convertible loan, they don't know at what valuation they are investing and thus at what price your shares can be converted in the future.
Normally convertible loans are used for bridge financing between equity rounds in order to provide liquidity for the startup to hold on until the next financing round happens.
This can be bad or good. In the former case, perhaps the startup hasn't managed to attain the objectives (KPIs) set by the investors of the previous round. In that event, cash can give the boost the startup needs to keep working on its growth until the next financing round. In the latter, the startup might be coming from a position of strength and they want to get some additional cash without too much negotiation that will help them to drive up the valuation for the next round.
Key concepts
Maturity
The moment in time when the loan matures and the investor can decide whether to get it repaid or convert it to equity.
Interest on the loan
The interest of the loan represents the typical interest on any kind of debt. When the maturity date is due, the full amount of the loan plus the interest is to be repaid.
Discount
The percentage discount is to be applied to the price-per-share in the event of converting the loan into equity.
Qualified financing
The minimum amount to be raised for the loan to be automatically converted. If the startup fails to raise it, the investor can decide whether to get the loan repaid or convert all the same.
Repayment
A convertible loan is an instrument of debt, so it will be treated as a liability in the startup's accounting book. In case of liquidation, first, the regular loan holders will get paid, then the convertible loan holders, and finally the shareholders.
Change of Control
If the startup is sold before an equity round, this appendix guarantees the shares can be bought at the same discount.
Valuation cap
The maximum valuation the investor is willing to accept when it comes to converting their loan to help them not to get excessively diluted.
Example
Let's say one wants to invest 100.000 € in a startup through a convertible loan. After some negotiations, the next terms are set:
- The loan is agreed upon with an interest rate, a discount & a valuation cap.
- Interest rate of 6%.
- Discount of 20%.
- Maturity date of 1 year.
- Valuation cap of 4M €.
After 1 year, there's an equity round where the startup is valued at €5M with 2M shares issued, hence selling at €2.5/share
Now the convertible loan plus the interest is 100.000+(100000*0.06) = €106.000€. The creditor can decide whether to cash out or convert the money into equity and decides the latter.
The valuation cap the investor set in the term sheet sets the maximum valuation at €4M so that's the maximum valuation at which the loan is going to convert.
The price per share with a valuation cap is calculated by dividing the valuation cap between the equity round valuation: 4.000.000 / 5000.000 = 0.8, and then subtracting the amount from the price per share: 2.5 - 0.8 = €1.7/share. That's the price set by the valuation cap.
However, there's also the 20% discount. With a price per share of €2.5, the applied discount amounts to: €2/share, which is higher than the price per share, so with both terms in the table the investor could opt for using the valuation cap.
In this case and having the two options in the term sheet, the investor decides to use the €1.7/share price and convert their €106.000 into shares at €1.7/share, amounting to 62353 shares in the company.
Have fun!