The funding dilemma
What has long been a standard for financing start-ups in Silicon Valley is gaining in popularity in Switzerland as well, thanks to its simple and quick implementation: the convertible loan.
A convertible loan is a combination of the two main ways by which a company can raise new capital, that is by taking on a loan (debt) or by issuing new shares (equity).
- With a loan (debt), the investor gives the company money that needs to be repaid at maturity plus interest, whereas the interest rate depends on the risk of default.
- In an equity investment, the investor receives shares of the company in exchange for cash.
Startups typically don’t have a credit history or recurring revenue to service the interest payments, which makes securing a traditional loan from a conventional lender (e.g. a bank) difficult and costly.
Raising new money by issuing new shares (equity) is the typical way of raising funds for startups, but it has its downsides too:
- establishing a valuation of an early stage company is notoriously difficult;
- raising money in the form of equity with a low valuation means the founders may have to give away large stake in the company at an early stage; and
- the negotiation of all terms (incl. a shareholders’ agreement) takes time and the transaction costs (such as legal fees) can be disproportionately high in the case of a low investment sum.
It is at the very early stages or between two financing rounds where the convertible loan can be the ideal instrument, both for the company and the investor. With a convertible loan, the company receives a loan from an investor, but with the twist that the loan is not repaid but converts into equity at a later stage, typically the next equity financing round. In the course of the next equity financing round, the parties or new investors will agree on a valuation of the company and negotiate all the terms of the round. This valuation and the negotiated terms can then serve as the basis for the conversion of the loan. Thereby, the parties can defer the valuation and negotiation of an equity investment to a later date and potentially to other investors.
A convertible loan represents a middle ground between equity financing and a traditional loan with (depending on the contractual structure) the following benefits:
- Simple, fast and cost-efficient implementation compared to an equity financing;
- no repayment of the loan and accrued interests; and
- conversion at an established valuation and thus a reasonable relationship between the investment sum and the stake in the company.
In the following, we take a closer look at the three most important aspects of a convertible loan agreement: conversion, discount and valuation cap. Conversion is about when and how the loan should be converted into equity of the company. The discount compensates the investors for the additional risk for the early-stage investment and the valuation cap guarantees a minimum stake in the company upon conversion. If the parties agree on both a discount and a valuation cap (which is standard), the discount is only applied if the value of the company less the discount is smaller than the valuation cap.
- With a valuation of CHF 10’000’000, a discount of 20% and a valuation cap of CHF 7’000’000, the discount is not applicable (CHF 10’000’000 *0.80 = 8’000’000).
Conversion
Cash is often tight for startups and is usually needed to invest in the development of the company. To avoid having to use cash to repay loans, it is agreed with the investor that the loan will be converted into equity if certain trigger events occur, and the loan will thus be offset by issuing new shares to the investor. Besides the most common trigger event, the next equity financing round, parties often agree that the loan shall also mandatorily convert into equity at maturity. This can protect the company, which typically is short of money at maturity and therefore has a weak negotiation position.
In order to prevent the founders from simply issuing a few shares at an inflated valuation to a friend and thereby triggering conversion at such high valuation, the equity financing must be ‘qualified’ to trigger conversion. The ‘qualified equity financing’ is typically defined as the next equity financing of the company which exceeds a certain ‘qualifying’ amount (e.g. more than a total of CHF 500’000 in new outside money) and which will be financed to at least a certain percentage (e.g. 50%) by new investors.
Conversion discount
In addition to the interest rate, which causes the total loan amount to increase annually, the conversion discount is the main driver for the benefit of the investors and compensation for the additional risk of an early investment. The later one invests in a (successful) company, the lower the default risk and thus the interest rate and discount.
The discount defines a reduction at which the convertible loan will convert relative to the valuation in the next qualified equity financing.
- A conversion discount of 20% means that if new investors invest in the company at a valuation of CHF 5’000’000, the holder of the convertible loan can convert the entire amount of the loan into equity at a valuation of CHF 4’000’000 (5’000’000*0.80).
For a company with 100,000 shares (before conversion and capital increase) and a valuation of CHF 5’000’000, the price per share is to CHF 50 (CHF 5’000’000 / 100’000).
- The convertible loan would convert into 2’000 shares (CHF 100’000 / CHF 50) without a discount.
- With discount, the convertible loan converts into 2’500 shares (CHF 100’000 / CHF 40) due to the lower price per share of only CHF 40 (CHF 4’000’000 / 100’000).
Valuation cap
In addition to the conversion discount, a valuation cap is also fairly common. The valuation cap is the maximum valuation at which the loan will convert. A lower valuation cap is better for the lender (and unfavourable for the founders) – the lower the valuation, the greater the stake that the lender receives.
- CHF 100’000 at a valuation of CHF 1’000’000 corresponds to a stake of 10%.
- CHF 100’000 at a valuation of CHF 10’000’000 only corresponds to a stake 1%.
The cap valuation gives an investor assurance that his investment will not be heavily diluted in the event of a sharp increase in the value of the company. On the other hand, a valuation cap can have a so-called anchor effect on future investors.
In the case of a large amount of outstanding convertible loans with a cap valuation of CHF 2’000’000, investors in a qualified equity financing round will try to shift the value of the company as close as possible to this cap valuation. Thus, a professional investor will very rarely accept too great a disproportion between his investment and the corresponding stake in the company and that of the investors with a convertible loan.
Example:
Let’s assume that we have two founders with 50’000 shares each.
| Shareholder | Founder Shares | Share % |
|---|---|---|
| Founder 1 | 50’000 | 50% |
| Founder 2 | 50’000 | 50% |
| Total | 1000’000 | 100.00% |
The company also has a convertible loan outstanding with the following terms:
| Convertible loan | Loan amount | Interest rate p.a. | Discount | Cap |
|---|---|---|---|---|
| Lender | CHF100’000 | 10% | 20% | CHF 3’500’000 |
After three years, company seeks to raise additional capital in an equity financing round. The founders are looking for CHF 500’000 of additional capital at a pre-money valuation of CHF 3’000’000. This funding event will trigger the conversion of the loan in the financing round as part of the transaction.
- With a valuation of CHF 3’000’000, the cap of CHF 3’500’000 is not applicable.
The terms of the financing round are as follows:
- Pre-money valuation: CHF 3’000’000
- Price per share: CHF 30
- Price per share (for convertible loan holder): CHF 24 (20% discount)
- Interest after three years (10% p.a.): CHF 33’100
When looking at the terms of the financing round above, we see that the company has 100’000 shares outstanding. With a pre-money valuation of CHF 3’000’000, the price per share for the new investor is CHF 30 (CHF 3’000’000/100’000 shares). Thanks to the 20% discount, the price per share for the loan holder is only CHF 24.
- The new investor receives 16’667 new shares (CHF 500’000 / CHF 30)
- The Lender receives 5’546 new shares upon conversion (CHF 133’100 / CHF 24)
The cap table after the conversion and the financing round looks as follows:
| Shareholder | Founder Shares | Investment | New Shares | Share % |
|---|---|---|---|---|
| Founder 1 | 50’000 | 40.91% | ||
| Founder 2 | 50’000 | 40.91% | ||
| Lender | CHF 133’100 | 5’546 | 4.54% | |
| New Investor | CHF 500’000 | 16’667 | 13.64% | |
| Total | 1000’000 | 122’213 | 100.00% |
This example shows three important things:
- The founders were diluted from 50% to around 41% of the share capital each
- Thanks to the discount, the lender has received 5’546 shares upon conversion (vs. 4’436 without discount, i.e. CHF 133’100 / CHF 30)
- The lender has also participated in the increase in value. After the investment of the new investor, the company is valued at CHF 3’500’000 (post-money). The original loan of CHF 100’000 converted into a share package worth CHF 158’900 (4.54% of CHF 3’500’000), i.e. an increase of more than 50%.
Conclusion
Compared to equity financing, a convertible loan is not only fast but also cost-effective. The convertible loan can be of particular interest to the company because, compared with a traditional loan, there is generally no repayment of the loan amount and no interest payment. Thanks to the discount early stage investors are rewarded for the additional risk they take by investing in a company without a long credit history or record. The cap valuation gives an investor assurance that his investment will not be heavily diluted in the event of a sharp increase in the value of the company.
