Lately, convertible loans have been gaining traction in the startup world. With increasing difficulties in setting high valuations for early-stage startups, convertible loans appear to offer a practical solution.
Our general advice for startups?
- Opt for a convertible loan if the total investment sum is lower than CHF 750’000 to CHF 1’000’000, unless you have been able to set a high enough valuation.
- The costs involved in an equity financing round are – most of the time – not in proportion to the investment amount if the total money raised is lower than CHF 750’000.
In this blog article, we’re turning our focus to two crucial aspects of convertible loans – the interest rate and the discount. But before we dive in, it’s essential to remember the importance of projecting the implications of a convertible loan on a cap table. Need help with this? Reach out to us to get your free cap table.
Understanding Interest Rates and Discounts in Convertible Loans
Borrowing money brings its own price tag. This truth rings particularly true when we seek funds from external sources, as these transactions come with associated costs. When we talk about convertible loans, these ‘costs’ manifest themselves through the application of either an interest rate, a discount, or on occasion, both.
Crucially, it’s worth noting that typically, neither the interest rate nor the discount gets paid directly to the lender (with certain exceptions). Instead, these amounts accrue and pile up on top of the original principal amount, eventually converting into shares at a future date.
Let’s first unpack the less complex component of these costs: the interest rate.
The Role of Interest Rates: Balancing Risk and Opportunity Cost in Convertible Loans
Engaging in lending entails a certain degree of risk for the lender, as there is always the potential for loan default, where the borrower is unable to repay the borrowed amount. The applied interest rate has a dual purpose: it not only compensates the lender for assuming this risk but also covers the opportunity cost incurred due to the lender’s inability to use those funds for other ventures or investments.
Additionally, in situations where the loan originates from a related party—such as existing shareholders – the Swiss Federal Tax Administration stipulates tax-recognized interest rates for loans. To avoid tax complications, these specified rates should not be exceeded when a loan is granted by an existing shareholder (as of the date of this blog, the interest rate should not exceed 3-5%).
For instance, consider a principal amount of CHF 1’000’000 with an applied interest rate of 3%. After two years, the total loan amount accrues to CHF 1’060’000.
As a practical advice, we commonly observe either zero interest or a rate ranging from 1-3%. However, we recommend concentrating more on understanding and managing the discount.
Leveraging the Discount: An Added Advantage for Early Investors in Convertible Loans
At its core, a discount shares similarities with an interest rate. This is because it affords the lender a greater number of shares at the time of conversion compared to those investing later in the equity round. In essence, it’s a form of interest expressed in equity instead of cash.
However, from a psychological viewpoint, the discount takes a more critical role. It acts as a powerful incentive for the lender to invest early via a convertible loan.
The discount essentially allows the lender to convert the loan at a price that is lower than the current market value or the price set in a subsequent funding round.
To illustrate, let’s say the issue price for new shares in the next financing round is CHF 10. If the lender is granted a discount of 20%, the loan will convert at an issue price of CHF 8 per share.
In other words, an investment of CHF 1’000’000 would translate into 125’000 shares for the investor -an additional 25’000 shares compared to the amount they would have received at CHF 10 per share.
In practice, we generally see discounts in the range of 10-20%. The further away you are from a significant equity round, the higher the discount is likely to be.
Interested in Convertible Loans or you just want to learn more about them? Don’t hesitate to speak to one of our Startup Financing & VC Experts!