Convertible loan 101 for start-ups

During our Spring Accelerator program of 2024 we discussed also the topic of convertible instrument. We picked some basic insights for you in this article. Enjoy! 

First of all, let´s say, what is the benefit of the convertible debt. A start-up founder signing a loan agreement with an investor offering a convertible loan (investor A) does not need to set the valuation of the company at this time. Investor A lends the money to the company and makes a deal: when a start-up enters another round of financing in the future and an equity investor (investor B) comes along, a debt of investor A will convert into equity.

Valuation cap

What to be careful about? Investor A lending money to a company can expect to have a "valuation cap" set up, often when they are worried the valuation will be much higher in the next round. Valuation cap is the highest valuation at which the convertible loan is converted into equity during the next financing round regardless of the actual valuation. When the price of the start-up skyrockets, investor A gets higher stake of the company in contrast to when the valuation cap is not present.

Lower or higher valuation cap?

What is the optimal decision for a start-up founder? It varies... With a lower valuation cap, founders will be diluted more when the investor B comes into start-up. However, simultaneously, with a lower valuation cap, investor A is considerably more motivated to attract a new equity investor in the next financing round. And this dynamic can be highly beneficial for the founder.

Potential investors coming after investor A interested in financing the start-up in exchange for an equity share, typically seek to review the loan agreement details and the valuation cap before submitting their term sheet with an offer and valuation. The valuation cap serves as a benchmark for determining the valuation in the round. Therefore, it is recommended to founders to first review the term sheet from the new investor and then provide loan agreements, if it is possible to do so in this order.

Why would investor decide for convertible loan?

From an investor's perspective, why might a convertible loan be more appealing than taking equity in a start-up? Equity investors contribute funds that become part of the company's assets, allowing the company and the founders to determine how the money is spent. In contrast, investors opting for a convertible loan lend money to the company distributed in installments based on predefined milestones set for the start-up. If founders fail to utilize the funds effectively or meet the established goals, the investor has the option to withhold further installments and request repayment. This grants the investor a degree of control over the start-up's expenditure.

March 28, 2024

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