Convertible loan

Convertible loan — a financial instrument typically used for investments in early-stage companies and startups.

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However, many entrepreneurs still don’t know what it is and how it works.

In the article below I summarized some basic information about Convertible loans.

A VC fund or an angel investor usually invests in early-stage companies via a convertible note and when a company raises the next round, investors convert that note into equity. In most cases, the conversion happens at a discounted valuation (valuation for early investors is less than for new investors) or with a predefined valuation (Cap) which is less than in the next funding round. It serves as a reward for the early investor.

Definition of the terms:

Discount Rate — establishes how much an investor is compensated for the additional risk he or she takes by investing in a company early on. For example, if a price per share is $5, then a 20% discount gives an investor a $4 price per share upon conversion.

The Valuation Cap is another way to reward seed stage investors for taking on additional risk. The valuation cap sets the maximum price that the loan will convert into equity. For instance, if the valuation cap is $10M and the new investor evaluates the company at $15M, the convertible loan of early-stage investors will be converted at a $10M valuation.

Interest — the convertible loan is a debt mechanism, hence an interest is established as a yearly percentage of the loan body.

Maturity date — determines the deadline for the loan to be automatically converted into equity in case no funding round takes place before the deadline date. Alternatively, an entrepreneur needs to repay it on previously agreed terms.

Benefits of Convertible Loan

• Convertible loan financing tends to be faster than priced rounds. There is no need to create a second class of shares or issue common stock.
• Convertible loan financing tends to be cheaper than priced rounds. Whereas the convertible note costs $2–5k, the cost of Series A round can reach $10–30k or more.
• Convertible loan financing tends to be simpler than priced rounds. This prevents a number of complications, including those arising from company valuations, stock option grants, and related tax implications.

N.B. The only time-consuming part here is agreeing on the valuation cap and discount rate.

When a convertible loan is used?

At early stages it is difficult to set valuation of the company, while issuing common stock might be more expensive than the total amount of the round itself.

Convertible loan mechanism allows entrepreneurs to focus more on operations and running the company and generating returns for the investors, without wasting valuable time on negotiations around valuation, etc.

In order to raise a bridge round before proper equity round. A company needs to reach certain traction and milestones via raising a small bridge in the amount of $300–500k. In this case, the convertible loan might become an admirable opportunity to get that bridge quickly and the investor can get on-board without additional hassle.

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Read more on our medium blog by following the link below:

What is a Convertible Loan?

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