In the wonderful world of start-ups and scale-ups, there are little to no guarantees in relation to an investor’s return on investment. Part of this uncertainty is self-evidently inherent to the more risky business that early-stage companies and start-ups stand for.
However, if you consider acting as an early-stage investor, there are ways in which you could (try to) minimize your downhill risk. One of the financing mechanisms that could help you achieve this objective, is granting a convertible loan to the company you are willing to invest in.
What exactly does a convertible loan entail, one might wonder? In this blogpost, we are ready to discuss the advantages and disadvantages with you and walk you through the process of granting a convertible loan in the seed stage of a company.
A convertible loan can be described as a hybrid financing instrument that combines the features of a loan agreement with those of an option (agreement). At the beginning of the agreement, a convertible loan may therefore be considered as a standard loan of which the modalities are set out in an agreement. However, given that it is a convertible loan, the interest rate shall be slightly lower than if it were a non-convertible loan. As a result, the lower rate is considered to be the equivalent of the option’s value
As outlined above, a convertible loan consists of a (standard) loan on the one hand, and an option on the other hand. The convertible loan’s option consists of the possibility to convert (a part of) your loan into equity of the company to which you have lent the money. As a consequence of such conversion, the debt claim shall be converted (through the procedure of a contribution in kind) in equity of the company, in exchange for which you - as the debtor - shall receive newly issued shares in the company. In short, a convertible loan can be seen as a loan agreement which can either be repaid in full on its maturity date, or, more likely, be converted into equity at a future date.
Venture capital funds and/or angel investors usually invest in early-stage companies via convertible loans, as this type of investment grants them the possibility of converting their loan into equity, during a next investment round of the company. Such conversions into equity usually take place at a discounted valuation (compared to the valuation that is applied to more recent investors in the firm) or a predefined valuation (“cap”) which will be lower than any of the valuations used in the next funding round. Converting the amount of the loan agreement into equity of the company is considered to be the early bird investor’s reward for its trust and support during the early/seed stage of the company.
One of the great advantages of convertible loans is that this hybrid financing instrument allows (early-stage) companies to quickly regenerate cash, often in anticipation of any future investments and/or equity funding rounds. Such quick cash regeneration is of utmost importance during the first years, and is a ‘win-win’ for both companies in need of cash, and investors looking to minimize their risk. Furthermore, convertible loans represent a financing method which in general is considered to be less time-consuming and less costly than an equity funding round. Exactly what an early stage company is looking for during the first few years of its existence.
The most important disadvantage that an investor may encounter is the situation in which the company has not proven to be successful. A first consequence hereof being that the interest rate of a convertible loan is considered to be lower than the interest rate of a standard loan agreement, meaning that the investor has realized a lower return on its investment. On top of that, the company may have become the subject of any insolvency proceedings, whereas the investor shall be treated as a debtor and not as a shareholder, given the fact that the investor has never converted its loan amount into equity of the company. The upside of this last point being that a debtor of the company is higher ranked than a shareholder in an insolvency procedure, and is therefore more likely to recover all or part of its invested amount. Which may also be considered to be an advantage if the company were to end up in troubled waters. The whole of these advantages and disadvantages makes it the perfect financing instrument for investing in early stage companies, while trying to minimize the downhill risk.
Would you like to know more about convertible loans or any other alternative financing mechanisms, do not hesitate to contact us. We are more than happy to discuss the possibilities with you.