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Understanding Convertible Loans: A comprehensive guide for Startups

Legal Know-How
May 29, 2023

Convertible loan - the convertible loan is an attractive financing option for founders

When founding a start-up, most founders are dependent on external capital, especially in the early stages: pre-seed and seed - i.e. immediately after founding the company.

Classical loans are most of the time not a viable option when it comes to raising capital due to a lack of collateral, low creditworthiness and a high risk of default. For this reason, many founders seek venture capital investors for start-up financing. In the earliest stages, in many cases those investors provide their money by issuing a convertible loan.

What is a convertible loan?

A convertible loan is a financing instrument in between a normal loan agreement and an equity financing
Venture capital investors provide money by granting a loan. The difference to a normal loan is, that it is not intended that the loan is paid back, but that the loan amount will convert into actual shares in the company. Hence the term convertible loan. The conversion event typically is the next financing round but may also be the maturity date of the loan or an early exit.

 
When the invested capital is converted into shares, the investors are usually granted a discount between 5-20% on the share price in the related financing round. The discount rewards the convertible lenders for coming on board as investors prior to the financing round.

What are the advantages and disadvantages of convertible loans for founders and investors?

A major advantage of convertible loans is that the contract between lender and borrower is comparatively lean compared to a traditional financing documentation and can therefore be signed rather quickly and with less transaction costs.

In addition, the commercial aspect of "valuing" the company (which is completed by founders and investors in joint negotiations) may be saved and shifted to the next round of financing.

However, investors need to be aware that convertible loans are typically unsecured and subordinated. If the start-up becomes insolvent, the lender has no security whatsoever and, moreover, ranks behind all other creditors (i.e. virtually in last place). In this respect, a convertible loan is similar to real equity.

Convertible loan terms investors and founders should discuss

When it comes to negotiating a convertible loan founders and investors should discuss the following terms:

  • Term of the convertible loan
  • Interest Rate (typically between 0.1 and 8.00 %)
  • Discount on financing round and exit
  • Valuation cap
  • Conversion events
  • In some cases. Guarantees
  • Information rights


How can GAIA help you when it comes to convertible loans?

As GAIA user you have access to a standard convertible loan template, which you can use. If you like you can get in touch with a lawyer from our partner law firms to get a customized template or legal advice with respect to your convertible loan. Additionally GAIA helps you to have an overview of all current convertible loans.
The most important contract terms such as maturity date, interest rate, discount and minimum valuation are clearly displayed so that you always have the key terms of the contracts at a glance. If it comes to the next financing round you can use our financing simulation to model your new cap table including the conversion of the convertible loans.

Janina Möllmann

CEO @ GAIA

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