Convertible Loan for Startups

Convertible loans are gaining popularity in Switzerland as an innovative financing solution for startups. They solve many of the problems inherent in traditional means of financing. That said, convertible loans do also come with their complexities and drawbacks. In this article, we take a deep dive into this exciting alternative to conventional financing. We discuss the challenges startups face when trying to acquire funding and how convertible loans can solve these, as well as outline their potential downsides. Finally, we help provide a thorough understanding of the various practical aspects of convertible loans.  

Financing a startup: what are the challenges?

While starting a new business is an exciting venture filled with opportunity, it comes with its difficulties. One of the greatest challenges for many startups is financing the business in its infancy. Traditionally, there are two ways to fund a business, both of which present obstacles for young startups:

1. Traditional loan from a lender (e.g., bank loan): It is often difficult for startups to obtain a traditional loan on favourable terms, if at all. Startups typically have limited collateral, no established track record or recurring income, and high risk associated with early-stage ventures. Traditional lenders are unlikely to grant a favorable loan under such circumstances.
2. Issuing shares: The other orthodox way of raising capital is through a new share issue in the company’s startup phase; however, this too has its downsides:
   • It is incredibly difficult to accurately value a company in its seed stage when tangible metrics of success are limited. As such, startups run the risk of undervaluing their company. Factors such as lack of market awareness, limited financial data, and underestimation of the company’s growth potential contribute to undervaluation early in the company’s life.
   • This effectively results in the company founders giving up a high share of the company to early investors at a significant discount, therefore depriving themselves of the full value of their equity. A low initial valuation can also make it challenging for startups to attract future investors or negotiate favorable terms in subsequent financing rounds.
   • Additionally, administering a financing round, including drafting a shareholder agreement and negotiating its terms and conditions, can be costly and time-consuming. The costs and effort involved may not be worth it for a small initial investment, especially when founders prefer to focus their energy on developing their core business in the early stages of the company.

Considering the critical issues with these two traditional methods of funding, startups can benefit by pursuing alternative financing solutions.

Convertible loans: an alternative to traditional financing

Amidst these challenges, convertible loans have emerged as a popular alternative for startups seeking capital funding. So, what exactly is a convertible loan, and why is it gaining traction among entrepreneurs and investors alike?

What is a convertible loan?

A convertible loan is a type of financing arrangement where an investor provides funds to a startup in the form of a loan, which, instead of requiring direct repayment, can later be converted into equity under predefined terms and conditions. Unlike traditional loans that require immediate repayment with interest, convertible loans offer more flexibility by deferring the decision on equity conversion until a future event, typically a subsequent financing round.

Purpose of a convertible loan

The primary purpose of a convertible loan is to provide startups with the necessary capital to fuel their growth and development while avoiding the pitfalls of traditional financing methods. They offer a viable middle way between a conventional loan and an equity investment.

One of the most beneficial aspects of a convertible loan is that it allows startups to postpone the valuation of the company to when they are more established and have a clearer idea of their worth based on tangible metrics and data. The conversion of debt to equity usually only happens when the startup is ready for its first/next round of financing.

Convertible loans are not only used in a company’s seed phase. They can also serve the purpose of “bridge financing”. When a company needs additional funding between two financing rounds (i.e., between new share issues), they may turn to a convertible loan with the agreement that the loan is converted into equity at the subsequent issue of new shares.

The role of the investors

Despite the name “loan”, convertible loans are not typically issued by credit institutions or other conventional lenders. They are usually granted by venture capitalists or “business angels”.

Business angels receive their name because they are the very first investors to provide the funding for entrepreneurs to develop and implement their business idea. Without a business angel, the startup may not have ever had the opportunity to launch their business. They take a personal approach and often contribute their own expertise and knowledge towards helping the business get off the ground in its seed stage.

Venture capitalists also look to invest early in businesses or other projects which they expect to be highly profitable, but usually at a later stage than a business angel. They typically provide much larger investment sums, ranging from hundreds of thousands to millions of Swiss francs. Venture capitalists are less involved in their investments at the personal level, often managing multiple of investments at once for themselves or on behalf of clients and firms.

Both business angels and venture capitalists may provide capital to startups in the form of a convertible loan in exchange for the potential upside of converting their debt into equity at a discounted rate later. By participating in convertible loan agreements, investors not only support early-stage ventures but also gain exposure to the company’s growth potential, benefiting from a discounted share price as well as interest return (the function of the discount and interest rate will be explained later).

What makes convertible loans so attractive for startups?

Convertible loans are often the method of choice for initial or interim financing for startups and companies in need of a liquidity boost. Whether it’s for funding product development, expanding market reach, or hiring key personnel, convertible loans offer a flexible financing solution tailored to the unique needs of startups.

Let’s take a closer look at the key advantages of convertible loans for founders and investors alike, as well as some of their drawbacks:

Advantages of convertible loans

1. Flexibility: Convertible loans offer startups the flexibility to access capital without immediately diluting ownership or setting a valuation.
2. Deferred equity conversion: Startups can postpone the decision on equity conversion until a later stage, allowing them to focus on growth without the pressure of immediate loan repayments or financing rounds.
3. Alignment of interests: Convertible loans help to align the interests of investors and founders, incentivizing both parties to work towards the company’s long-term success.
4. Speed and Affordability: Convertible loans are simpler and cheaper to administer than taking a conventional loan or issuing shares. They require less arduous paperwork, there is no need for expensive notarization, and transaction costs are much lower. They are also faster to implement, saving the founders precious time and providing immediate access to funding when they need it most.
5. Maintain control: The lender of a convertible loan is not yet considered a shareholder or partner. This means they have no co-determination rights or direct decision-making power. The founders can therefore continue to act independently in developing the business in the way they see fit. They must, however, keep in mind the investor’s right to information.
6. Investor also benefits: Convertible loans can also be highly advantageous for the early investor providing the loan. Although they are taking on a high risk, the loan allows them to secure early shares in the company at a reduced and often attractive price. The return on investment can be substantial if the company goes on to be successful.

Disadvantages of convertible loans

1. Uncertainty: Since the conversion terms are contingent on future events, there is inherent uncertainty regarding the final equity conversion price and dilution impact.
2. Low valuation: If the startup is forced to convert the equity at the first financing round, they may find that the company has not yet progressed as much as they hoped, leading to a low valuation. Equity may then be significantly diluted without receiving much capital in return.
3. Issuing shares at a discount: Investors who provide a convertible loan usually receive a significant discount on the share issue price at the time of conversion, which can be as much as 30 percent. While the discount is necessary to persuade investors to take on the early risk, it results in dilution of equity at a reduced value.
4. Valuation cap: Convertible loans often contain a valuation cap clause, which sets the maximum purchase price of shares for the investor providing the loan. This puts an upper limit on the company’s value, and therefore dampens the benefit to founders if the company is worth much more than the cap at the time of conversion.
5. Potential downside for the investor: Savvy investors may be able to generate high returns by providing convertible loans to startups; however, they are also regarded as a high-risk investment with significant downside potential. Investors may lose part or all their investment and should be prepared for such a possibility. If the company is unsuccessful and never gets to the point of converting the loan into equity, the investor is most likely to lose out completely because they fall below other creditors in terms of payment priority (qualified subordination of convertible loans means that all other debts must be settled first).

Practical aspects of a convertible loan

While the basic principle of convertible loans is quite simple, there are various practical aspects to understand. Convertible loans can differ greatly in their specific terms and conditions. Their highly variable and customizable nature is a benefit on the one hand but adds complexity on the other. Here, we briefly explore the most important practical aspects of convertible loans:

Contract contents

Depending on the specific type of convertible loan and its terms, the contract can include numerous clauses. Typically, a convertible loan contract includes at least the following:

• Loan term: the loan term is the maximum duration before the company is required to either convert the loan into equity or repay it.
• Interest rate: the annual rate of interest payable on the loan.
• Discount: the percentage discount the lender (investor) receives when the loan is converted to equity.
• Other special clauses: valuation caps, specific rights and obligations of each party, trigger events for converting the loan to equity, and various other special clauses may be included.

Loan amount and interest

The value of a convertible loan can vary massively and could be anything from a few thousand to millions of Swiss francs. It just depends on the startup’s capital requirements and the willingness and financial capacity of investors. Interest rates for the convertible loan are also agreed upfront, which can also vary widely.

Most convertible loans tend to have interest rates between 4 and 10 percent but interest may be waived completely if the conversion date is soon. Longer-term loans warrant higher interest rates for the additional risk.

The way in which interest is repaid is also stipulated in the terms of the loan contract. Often, interest is handled separately from the conversion, meaning that the startup repays the interest in cash while the principal loan amount is converted to shares.

However, they may also agree to convert the interest into equity at maturity along with the principal instead of repaying it separately.

Loan term

The term for most convertible loan contracts is one to three years but can be as little as 6 months. It’s not recommended to omit the duration from the contract just because the company is not yet clear about when the next financing round will be, as this can lead to unclarity and disagreement between the investor and company.

The investor then has the legal right to terminate the loan at any time which carries the risk of the investor requesting repayment before the company has sufficient liquidity.

Some convertible loans may contain a maximum term, with additional trigger events that would cause the loan to be converted to equity before the end of the term. For example, a new share issue (financing round) could give the investor a contractual right to convert the loan into equity at the issue price less the agreed discount rate.

Conversion and repayment

Some convertible loans may be subject to mandatory conversion if a financing round occurs within the agreed loan term. This means the investor has no option but to convert the loan to equity unless the startup fails to issue shares within the timeframe and are therefore obligated to repay the loan amount plus accumulated interest.

On the other hand, the loan may stipulate that the investor has the right but not the obligation to convert the loan to equity. This means that they can request repayment of the loan instead of conversion if they so choose, even if the startup does have a financing round. The investor may opt for repayment if they feel the shares are overpriced and therefore not a profitable investment.

Discounts and valuation caps

The provider of a convertible loan takes on greater risk at an earlier stage than a conventional investor who takes part in the company’s subsequent financing round. The small interest rate is hardly sufficient to compensate for this higher risk. Therefore, there must be some incentive for these early investors, hence the regular inclusion of discounts and valuation caps in convertible loan contracts.

Discount

Convertible loans typically include a discount rate on the company valuation. The discount is usually between 10 and 30 percent

This is the rate at which shares are discounted when the loan is converted to equity.

For example, if the agreed discount rate is 20 percent, and the company issues shares at CHF 100 each in the next financing round, the lender of the convertible loan would be able to convert the loan to equity at a price of CHF 80 per share.

Valuation cap

In addition to the discount rate, the convertible loan contract often places an upper limit on the company valuation when it comes time to convert the loan to equity at the next share issue. This is known as a “valuation cap”.

These are commonly demanded by investors and are difficult to avoid for the startup. The valuation cap protects the investor from the company issuing shares at an inflated price thereby reducing the value for the investor.

It also means that the investor can really win big in some situations where the company has much greater success than anticipated.

For example, suppose a startup makes a significant breakthrough in the market and ends up valuing their company at CHF 5 million with 10,000 total shares. The actual nominal value per share would therefore be CHF 500 at the next financing round.

The same company had taken a convertible loan which stipulated a valuation cap of CHF 1 million, not anticipating just how successful they would be.

This means that the lender would be able to convert their loan to equity at a share price of CHF 100 per share, effectively acquiring equity at 1/5^th the actual issue price. This is an extreme example, but it illustrates how there could be substantial upside for investors willing to take the early risk of providing a convertible loan.

Qualified subordination

Most convertible loans come with a qualified subordination clause, which means that all repayment claims from other creditors and lenders are settled before those of the investors providing convertible loans.

In other words, a convertible loan is the last “debt” to be settled by a company in the case of insolvency, which basically equates it to equity when it comes to the hierarchy of debt repayment.