Convertible Loans

What Tech Founders Need to Know

Definition

A convertible loan is a loan that´s meant to convert into equity (normally including any accrued interest) instead of being paid back.

When is the loan convertible?

The conversion is made dependent on the occurrence of a certain event, the so-called conversion event. Depending on the specific terms and conditions of the convertible loan, conversion events can trigger either a conversion right and/or a conversion obligation.

What will be the price per share on a conversion?

The amount of equity the loan converts into is based on the valuation calculated at the next funding round.

  • or (more commonly) at a discount against the price achieved per share in the qualifying round of funding. A discount gives the VC a price reduction on the debt´s eventual conversion to equity.
  • During the term of the convertible loan, the existing shareholders are not diluted, the (legal) cap table remains “clean”.
  • Compared with the consummation of an equity financing significantly lower transaction costs and faster (short-term) implementation.
  • The difficult process of company valuation can be deferred to the next financing round.
  • Convertible loans allow for the establishment of a manageable and less complex governance structure (for example with respect to information obligations, consent rights, etc.).

Disadvantages for Founders

  • Getting a lot of convertibles can be a dangerous game — more investors on board means your cap table can get crowded quickly and negotiations time-intensive and messy.
  • In case of a lower than expected valuation on the next rounds, this could mean that you have to give away more shares than you plan to.
  • In case the company cannot request the conversion of the convertible loan, this might negatively impact future financing rounds (inherited liability).
  • If and to the extent no conversion occurs, the loan amounts (including interest accrued) need to be repaid, which results in a loss of liquidity.
  • If a conversion occurs as part of a (future) financing round, additional shares are issued and existing shareholders are (additionally) diluted, even though no additional new capital is raised.

FAQ

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More Reading

Greulich, S., & Kaniak, C. (2019). Convertible Loans for Tech Companies. Orrick Legal Ninja Series — VC & TECH Briefing Germany, 1–81.