A convertible loan is a business loan that is mainly concluded between startups and investors. It is a loan that can be converted into shares after a certain period. In the meantime, a benefit is not possible. This gives the startup the chance to finance the first years of its business, without making too many costs. It sounds very simple now, in practice there are of course some hooks and eyes. A convertible loan is also called an ‘overdue’ loan. That sounds inferior, but actually it is one of the most flexible forms of lending that exist. (Technological) startups often request the convertible loan to finance the first years of their business. In this article you can read how exactly that works and what you can do as an investor.
What is a convertible loan?
With a convertible loan, repayment is therefore postponed to a later time. The average duration is 5 to 7 years, with a grace period of 3 years. Experience shows that a start-up company needs this time to invest itself and make the company profitable. The investor lends the amount for a fixed interest rate to the company. The first one to two years there are no redemption costs. If the financing of the business is complete, the loan is converted into shares (often with a discount) or the investor can request the money back with interest.
After the grace period, investors can choose to convert the loan amount into shares + interest, or to hold the loan. This choice depends on the value in use at that time. You get the shares depending on the company value. If the investor holds the loan, the company is obliged to pay out the loan and interest within the specified term.
Early conversion to shares
Sometimes there is a new investor during the grace period. In that case, you can convert the loan to shares early, so that you can still benefit from the financial success of the company. As an ‘early’ investor you often get a discount on the shares. That is why it pays to invest early. On the other hand, you run more risk because you do not know how the company will develop in the future.
Who is a convertible loan for?
The convertible loan is a business loan, so no consumer loan. Two parties are involved in the convertible loan: a (starting) company and one or more investors. How does a convertible loan work for one company and for an investor?
A convertible loan is ideal for start-ups. In the first years of a company many costs are incurred, which can not always be covered. Income usually only starts more often. To generate a cash flow up to that time, a company can choose to issue a convertible loan. In this way, the company has enough starting capital. The moment of repayment comes later. A convertible loan is of course only suitable if you expect your company to grow rapidly. Money lenders have to share this expectation with you, otherwise they invest nothing.
As soon as you convert a convertible loan, investors can choose to invest in the start-up company. For this, the investor will extensively investigate the plans of the company. He will use all information to estimate the future value of the company. It is essential that the loan is repaid with interest. If you invest in a company that indeed grows quickly, it can be a pretty lucrative business. Are you planning to invest through a convertible loan? Then get in as early as possible. You often get a discount, which means that you have ‘more value for money’ at a later stage.
Who can invest all?
Any business lender of 18 years and older can invest. Provided that this person lives in the Netherlands and is legally competent and competent. In addition, it is required that this person is registered with the Chamber of Commerce.
For companies, they must have growth potential. Innovation is often the keyword here. If an investor does not believe in the growth potential of a company, the company can whistle to the convertible loan.
The maximum valuation cap
The company and the investor can agree in advance that the loans will be converted to the maximum value at that time. So if the company becomes worth more than the original valuation, the investor gets more return. In this way, the gap between many risks and low returns is trying to close. However, the maximum valuation cap is not a standard appointment.
The level of interest rates
Interest rates of a convertible loan were often slightly lower than those of a regular loan. Depending on the conditions (which vary per loan), you can assume a percentage between 4% and 10%.
The term of the loan
The term of a convertible loan is also fixed in advance in the conditions. Usually the term of a convertible loan is between 5 and 7 years. However, the term is not the same as the grace-free period. The redemption period is often the first or first and second year of the total term. This also differs per convertible loan.
What are the points of attention of a convertible loan?
Borrowing is never without risks. This applies to a convertible loan, but just as well to bonds and other forms of bonds and shares . Below we will briefly mention the points of interest.
Starting points for starting business
You have not started your new business for nothing. There is a good business plan, based on a gap in the market. The only thing missing is a bag of money to realize the sky-high ambitions. A convertible bond means starting capital, but you have to pay it back in one day. With interest. There is always a risk that your company – for whatever reason – becomes less profitable, or even goes bankrupt. In the event of bankruptcy, the creditors always go for it.
Every entrepreneur from the age of 18, who is demonstrably legally competent and qualified, can apply for a convertible loan. The convertible loan is especially popular among startups and new entrepreneurs, because there is no repayment in the first years. That is very nice in the initial phase of a company, because there are still insufficient resources to finance everything. Convertible loans are only suitable for innovative and fast-growing companies; otherwise investors will not see any bread in it.
In addition, it is not always guaranteed that you can get enough investors. This means that investors and shareholders have a certain value attached to their ‘trust’ in the company. If they find the company too big a risk, they invest less. Or not at all. So you really need a good plan and the commercial insight to convince investors. Maybe someone in your network can help you with that.
Issues for investors
In fact, you can also reverse the above argument and apply it to investors. Because it seems like a very safe investment – after all, repaying the loan continues. Moreover, you have read the business plan: waterproof and very lucrative. Unfortunately, you can not predict the future. That certainly applies to the economic market. So if the company unexpectedly flops, you can whistle to your money. How much right you have on it – a bankrupt startup does not have a piggy bank to pay you. In that respect, it is sometimes safer to invest in a company that has been established for some time.
A convertible loan can only exist if there are sufficient investors to lend the money. As an investor you have to take into account that during the first 1 to 2 years of the loan you will not see anything from your assets. However, this does mean that you can exchange your invested capital for relatively cheap shares in the long term. If the start-up indeed grows into a successful company, then you have a lot of profit to deal with. Fortunately, you can also choose to have your loan repaid including an agreed interest.
Secondly, investors get the chance to have their investment repaid in shares. Every time an investor does that, the company gets a new investor. It’s like a cake: the more people, the smaller the pieces of cake. So when new investors join you, your total share becomes smaller. On the other hand, it means that the company can apparently pay off the loan. A sign that a lot of income is coming in! An extra guarantee that your shares are worth money.
A final point, both for investors and for startups, are the conditions in the agreement. We will go back to that in detail in the next paragraph.
The risks of a convertible loan
A company can be so promising, but it can always go bankrupt. Some market developments are simply unpredictable. In that case, you as an investor are stuck: all creditors are given priority in the event of bankruptcy. In addition, there may be time pressure for the company itself if resources have not been found in time to pay the large repayment. A solution is that the company automatically converts the loan to shares on an agreed date. That is a risk, however, because who wants shares in a company that does not grow as fast as expected?
Convertible loan: what is in the agreement?
A very important part of a convertible loan is the agreement. Here are all conditions. It is important to ensure that all parts are returned in the agreement. And that you know what is there and decide for yourself whether you agree with the conditions – yes or no. Pay attention to the following points in the agreement:
Height of the convertible loan
The amount of the loan is surely the starting point for most convertible loans. Which investment do you need to finance your starting business? Is this a real amount? And more importantly, do you expect that you will actually generate the income to repay the loan over time (including interest)? It is good to let go of some calculations on the amount of your convertible loan. Similar questions apply to the investor. What can I invest? What do I want to invest? Do I have sufficient confidence in the start-up company? Is it a realistic amount?
Interest on the convertible loan
The fact that the interest on a convertible loan is not paid out in the meantime does not mean that there is no interest at all. On the contrary. The interest means additional costs for the entrepreneur. For the investor, the interest means that he or she receives additional shares.
Moment of conversion and possible discount
As we have explained above, a convertible loan has a certain moment when the loan can be paid out in shares. The sooner an investor ‘gets in’, the greater the risk for him or her. At the same time, those early investors are extremely important for a start-up company. That is why you want to reward the first investors. This is usually done by offering current investors a discount with regard to investors who enter at a later date.
The valuation cap (also called ‘cap’)
The valuation cap is a way to protect an investor. This means that the investor will receive a minimum percentage of the total shares (instead of a fixed amount). The following calculation example shows why this can be advantageous for the company:
- Situation A: the investor gets € 10,000 on an agreed date, say 1 March 2019.
- Situation B: the investor gets 10% of the business value of the company on an agreed date, say 1 March 2019.
When a convertible loan is taken out, a certain value of the company is assumed on 1 March 2019. In this example, the company would be valued at € 100,000. In situation A and in situation B, the investor will both receive € 10,000. However, it may also happen that a new investor enters at a later time. He makes a large investment, so that the value in use on 1 March 2019 amounts to € 120,000. In situation A the investor gets € 10,000 and in situation B € 12,000. So you see that the investor who invested early profits from a maximum value cap. The cap is 10% in this case, but can be determined in consultation.
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