All you need to know about Convertible Notes

What is a Convertible Note

A convertible note (also kown as convertible loan) is a short term debt financing that converts into shares in the company as soon as certain conditions are met. Other that the name suggests convertible loans are much closer to equity than to debt. The lender who is issuing a convertible to a startup intends to convert his claim from the loan (incuding interest) into shares in the company. Convertible Notes are a form of mezzanine financing as the claim from the loan stands behind other form of debt and tend more towards being equity capital.

Key Parameters of a Convertible Loan

Convertible loan agreements (CLA) are pretty straight forward contractual agreements. Terms you normally find in CLAs are duration, conversion price, discounts, valuation floor and cap, interest rate as well as information rights and governance. I will briefly touch on these key terms to provide you with some tips and tricks on how to finance your startup with convertible notes.

Maturity Date and Conversion into equity

CLAs are a short term instrument that converts into equity. The normal duration is usually between 12 and 18 months. The conversion into equity can be triggered by a next round of financing, an early exit or the end of the loan duration. The most common trigger event is a next round of financing. Often this is called a “Qualified Financing”, which usually defines a certain minimum amount that needs to be raised.

In case of a Qualified Financing the outstanding loan amount including the acrued interest converts into shares. CLAs usually contain early exit clauses as well as clauses for a conversion at the maturity date. In case there is no Qualified Financing before the maturity date it’s normally up to the investor to decide wether or not he wants to convert the loan into shares. The investor then has the right but not the obligation to convert the loan. This is an important difference because if there is no obligatory conversion then the loan has to be repaid. In most of the cases I have seen repayment is not really an option and would lead to bankrupcty of the company.

Subordination

Convertible loan agreements usually contain a subordination clause in order to avoid being treated as debt in the commercial balance sheet. This is mainly to disregard the loan obligation in the overindebtedness status pursuant to insolvency laws in case of a bankruptcy. However, as the lender are still no shareholders their claim has still a preferred status compared to regular shareholders.

Conversion Price, Floor and Cap

One of the key deal terms for convertible notes is the conversion price. It´s one of the major advantes of convertible loans that you don´t need to agree on a valuation in the moment you sign them. However, founders and investors need to agree on the conditions under which the CLA converts into equity. Most often this is done by referring to the valuation of the next financing round, a floor and cap.

The cap sets the maximum price at which the loan converts into equity. It provides an upper limit to the investor and gives him some comfort that the conversion price won´t exceed this price. The floor on the other hand is the lower limit or a minimu price at which the note converts and protects the founders from giving the shares away to cheap. The actual conversion price will depend on the price of the next financing round and will most likely be within these boundaries.

Convertible lenders provide financing early in your companies life. They don’t become shareholders in the first place. To compensate them for the risk they are granted a discount on the shareprice of the next round.

Convertible Notes Discount

As early backers of the company convertible note lenders normally get discount between 10% and 30% on the shareprice of the next financing round. The conversion price is calculated by subtracting the agreed discount from the share price paid in the equity round (or exit transaction) where the conversion happens.

Dilution from Convertible Loans

At some point CLA will convert into equity and consequently will dilute the founders and existing shareholders. As a founder you should not underestimate the dillution effect convertible notes can have, especially if they have agressive caps and discounts. The new investors sets a valuation on a fully diluted basis, thereby treating the convertible note as if it was already converted into shares. The conversion of the loan dilutes the founders and existing shareholders. Let´s do a simple example:

  • An investor injects 1 Mio. EUR through a convertible note with
  • The agreed pre-money valuation cap for the conversion is 4 Mio. EUR
  • For the next round of financing new investors suggest an investment of 5 Mio. EUR based on a pre-money valuation of 10 Mio. EUR on a fully diluted basis

In the above example the CLA would convert at the cap of 4 Mio. EUR, which gives the former lender a stake of 20% in the company prior to the new money coming in. The dilution is born by the founders and other existing shareholders.

The new investors valuation of 10 Mio. EUR on a fully diluted basis treating the loan as if it was already converted. Any dilution coming from that conversion does not affect the new investor. He will own a third of the company after his investment (5 Mio. EUR / (10 Mio. EUR + 5 Mio. EUR)).

Issuing a lot convertibles with agressive caps or discounts can cause significant dillution.

Interest

Convertible Notes normally carry interest of 2% to 8%. Interest payment usually accrues until the conversion. It converts into shares together with the nominal amount (payment in kind).

Information Rights, Pro Rata Rights and Governance

Convertibles lenders don´t become shareholders in the company and so they are missing certain rights and governance standards. By implementing a minimum of rules lenders can be treated as if they were equity holders. This mainly adresses certain information rights (e. g. monthly investor reporting) and reserved matters, for which the management needs the approval of the investors. In addition investors like to secure their pro rata rights for the next round of financing.

The pro-rata right, i.e. the right of the investors to subscribe to new shares in proportion to their existing stake already held in the company, is one of the most important investor rights. It helps the investors to increase their exposure if the startup performs well after the initial investment. Since as lender there is no statutory pro rata right (because this only exists for shareholders) it needs to be incorporated into the convertible note. So the lender is treated as if his loan was already converted.

Advantages of Convertible Notes

Financing the company using convertible instruments has a lot of advantages:

  • CLAs are a fast and less complex way to raise founds for your startup in its early stages or prior the next major round of financing (you don´t need lenghty contracts including excessive governance)
  • Transaction costs are lower using CLAs
  • CLAs can have attractive conditions for investors
  • There is no need to agree on a valuation when using a convertible instrument. This prevents setting undesirable benchmarks for the next round of financing
  • Convertible Notes a are eligible for public subsidies in certain jurisdictions

Disadvantages of Convertible Notes

Potential disadvantes of CLAs include:

  • CLA bear the risk of considerable founder dilution through the loan amount, interest and the agreed discount. So as a founder be careful with to aggressive caps
  • In case the loan has to be repaid at maturity (because there is no obligation to convert it) CLA might cause significant loss of liquidity
  • Convertible lenders are not shareholders of the company. They rank behind other debt financing instruments. But, they are still preferred to common equity in case of an insolvency or exit.

Why and When to use Convertible Note Financing

Use Convertible Notes…

  • when you just need some more time to close your next round of financing. Providing liquidity through a CLA gives you room to maneuvre and finalize the negoations without the pressure of running out of cash. You should still limit the amount you raise and be carefull with the signalling when it comes to caps and discounts. A new investor might use them as an anchor point in his negotation.
  • if you cannot aggree on a valuation with your potential investor. Financing through a CLA leaves the pricing of the round open (within certain boundaries) until the next round of financing.
  • in the very early phases for your startup, when the time and cost of doing an equity round are simply to high and the amounts you raise are too small to justify the cost of doing all the contractual work.

Conclusion

As with all things in life nothing is perfect. Convertible notes represent a quick and fairly easy instrument. They are used for bridge financing or in very early stages of the company. It saves time, effort and costs and avoid a lot of administrative hustle. Used carefully it can be a very good mean to bring your company to next level. However, be aware of the potential drawbacks of CLAs. They might send a bad signal to new investors if the caps and discounts are to aggressive.

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