Convertible Debt

A convertible debt or convertible loan is short term debt that converts into equity at a future date also known as

bridge loan. They are a kind of financing instruments that helps to minimize time as compared to equity

funding, also is often less expensive compared to the equity financing techniques. Convertible debt helps start-

ups to have a quick and easy access to cash. The investor and the investee company will negotiate the ‘trigger’

for the conversion of the loan terms into equity shares. This will be either a negotiated date or a qualifying

round of equity financing. The investor will want the threshold amount to be high enough to ensure that, if the

loan does convert to shares, those shares are in a company which is both promising and adequately funded. The

start-up, however, will want to ensure that the stipulated amount is both practical and feasible.

Advantages of convertible debt

Advantages of convertible debts for both investor and company include:

• The advantage from the perspective of an entrepreneur is that a convertible debt before its conversion

treated as a standard loan. The investor does not have many benefits and rights of a preferential

shareholder like board seats etc. It also completed faster since it is a short and simple document, which

is why convertible loan investment can be processed more quickly than equity investment.

• Convertible debt provide opportunity to raise cash quickly if funding round is not possible and it does

not require immediate payment of interest, instead it will be accumulated and transferred to equity at a

future date.

• The deferral of a company’s valuation, allowing time to raise the share price and in exchange, reduce

the amount of equity that the company needs to give away at lower share price.

• Control of the company remains with the existing founders and shareholders as the investor would

usually pursue nominal rights as a lender like information rights, matter requires concerns, etc. Investor

would be eligible for additional rights after the conversion of the loan.

• Investor has a right to subscribe shares at a discounted rate if the company does well and raises

investment and if the company fails to raise additional funding, the investor can either seek a loan to be
 repaid or in case of insolvency, place ahead of the shareholders of the company, and a valuation cap on

a qualifying funding round guarantee that the investor has a minimum percentage of equity if the

company’s valuation is higher than expected.

Disadvantages of convertible debt

Disadvantages of convertible debt for both investor and company include:

• Convertible debt funding does not qualify for seed enterprise investment scheme or venture capital

investment which is why it is not as attractive for investors.

• Negotiation over valuation cap cost time and money to company and if the convertible loan investor

gets the significant discount on the price paid for shares on a qualifying funding round then this may

impact the valuation of the company in future rounds as potential investors would not want to pay a

much higher price.

• Very few investor rights prior to conversion and investor would not be eligible for more important rights

if not meet the criteria set by the future investors in funding round.

• Until the loan gets converted to equity, the investor has a priority right at maturity date to claim any

assets or put penalty to get the loan and interest repaid.

The standard terms and conditions to in the convertible debt which makes both investor and company to reduce

risk and provide transparency in future also provide better understating to the potential investors.

• Maturity date: The maturity date refers to the period at which the borrower must be repaid the loan to

an investor. In simpler terms, it refers to the due date on which a borrower must pay back loan in full.

The investor can ask for repayment of the loan at the maturity date if conditions would not meet. This is

used to protect investor if the start-up is not doing well and unable to raise the funding round.

• Interest rate: The interest rate both investor and company decided at the time of convertible loan. It is

also known as payment in kind since company or start-up does not pay in cash but in equity. Interest

gets accrued to the loan and at the time of conversion, investor gets equity together with the principal of

the loan. Example: if investor give €100,000 convertible loan with an 10% interest that gets converted

into equity in 12 months, the actual amount that gets converted is €110,000. The standard interest rates

vary between 5% to 10% and minimum period is 12 months.

• Conversion: Conversion is the essential terms that describe the conditions under which the loan will be

converted to equity. The standard conversion scenario is upon qualifying financing round or next

financing round, but it also varies to investor as well. The qualifying financing round can be defined as

multiple of qualified transaction. Example if the loan amount is €500k and qualified transaction is 2x

than start-up must raise more than €1 million for qualifying round to convert loan to equity. If finance

round is above €1 million than the loan gets automatically converted into equity. Also, investor have

right to decide whether he wants to convert before or at the financing round.

• Conversion discount: The investor converts his loan to equity with conversion discount on value

relative to new buyers to compensate for the added risk of having joined the start-up earlier than new

investors. Conversion discounts provide opportunity early investors to get equity at decided discounted

rate in next funding round. Example new investors are investing in the start-up at €5 million valuation.

If the loan has a 20% conversion discount, the holder of such a loan can convert the entire amount of the

loan and interest to equity at 5,000,000 * 80% = 4,000,000. Standard discount rate usually in convertible

debt is between 10% to 30%.

• Valuation cap: In addition to a conversion discount, investor can also set a valuation cap. Valuation cap

is the maximum valuation at which the loan will convert. This provides additional benefits to the early

investor. Example in the above scenario if valuation cap at €3 million than convertible debt investor can

convert to equity at €3 million instead of €4 million. Investor will get equity as cheaper price as compare

to new investors.
 Reference

Whu.edu. (2020). Course: Venture Capital Finance-E- Additional Course (MSc, Fall 20). Available at:

https://moodle.whu.edu/moodle/course/view.php?id=3966.

Mark MacLeod. (2016). What you need to know about Convertible loans - StartupCFO : Mark MacLeod.

Andrej Kiska (2014). What Is A Convertible Loan And Is It Right For Your Startup?

Investopedia. (2020). An Introduction to Convertible Bonds.

Alasdair Madden (2020). Convertible Loans: key terms, advantages and disadvantages. Lexology.com