What is a convertible loan?
A convertible loan is a short-term form of debt which will either be repaid or, in most cases, convert into equity at a future date. Compared to a traditional equity round where shares are sold in exchange for capital, a convertible loan is cheaper, faster and simpler.
Before its conversion, it behaves like a standard loan: control usually remains with the existing shareholders and the investor has a priority right to claim the debt at the date of maturity. If converted, the investor becomes a shareholder according to the terms of any existing corporate documentation, the new documents being entered into on a qualifying financing or specific investor terms set out in the loan agreement.
Companies in their early stages, especially in the technology sector, usually need to raise cash quickly in order to fund marketing campaigns or product developments. Convertible loans are the easiest way to access funds when the legal and procedural expenses of issuing shares are higher than the capital generated.
If the company is profitable during the period of the loan, it will increase its share price at the next equity round. This allows the company to raise more capital by issuing fewer shares.
Alternatively, convertible loans can be used if a company needs to cover short-term expenses until long-term funding is secured. This type of debt is called bridge funding and it is usually used to solidify a company’s position until a long-term financing option can be arranged.
The loan agreement will include the conditions under which the loan is converted into equity. Generally, other than default and insolvency (which no growth company wants to talk about), conversion events are separated into three categories:
Conversion will occur if the company is raising an amount of capital above a particular threshold through an equity round.
Conversion will occur either on a sale of its shares or its material assets or through an Initial Public Offering (IPO).
Conversion may occur (usually at the lender's option) on the agreed repayment date if that date is reached and the loan has not yet converted or been repaid.
Upon conversion, the amount borrowed plus interest (typically between 6% and 8%) will convert into shares that the lender will be issued at a discounted price. The discount rewards a lender by offering a better share price than the share price being offered to investors on the qualified financing round. Typically you will see a discount rate between 10% and 30%.
Investors often seek a valuation cap which would be agreed up front and documented in the loan terms, which sets the highest valuation that will be used to calculate the conversion price. So, even if the company is valued above the valuation cap at the qualified financing round, the loan will convert at a price based on the valuation cap, and the lender will receive a greater ownership of the company.
Please note that the following names and figures are fictitious.
AppsForEveryone has recently developed a new app and is looking to fund the app’s marketing campaign. The estimated cost for the campaign is £100,000. AppsForEveryone believes that its share value will increase significantly after the transaction.
FundsForApps, an investors network, is willing to provide a £100,000 2-year convertible loan because it believes in the success of the app. The loan has a 6% interest rate and 20% discount rate on a conversion.
After the first year, AppsForEveryone has grown and in order to further develop it wants to conduct an equity round in order to raise £2m (inclusive of the outstanding loan) by issuing 1,000,000 shares which will be a qualifying financing round. The price per share is £2.
At this point, the amount owed by AppsForEveryone to FundsForApps is £106,000 (the initial loan amount of £100,000 plus 6% of interest). However, the equity round has triggered a conversion event as it is a qualified financing round.
The loan will convert at a 20% discount on the qualified financing round's share price (£0.40) resulting in a conversion pice of £1.60. Out of the 1,000,000 shares on offer, FundsForApps will be issued 66,250 for converting its outstanding loan and interest amount of £106,000.
Had FundsForApps waited until the equity round to invest, it would have received only 50,000 shares in the company for its £100,000.
We work with companies and investors in preparing convertible loans and loan note instruments and conducting financings using all types of debt instruments. Please get in touch with us today or book an online consultation to discuss how we can help.