This guide explores convertible loans as a hybrid financing instrument for early-stage startups, explaining how they bridge the gap between traditional loans and equity financing, their key advantages for founders, and the essential terms to negotiate with investors.
When starting a new venture, most founders rely on external capital, especially in the early stages like pre-seed and seed, essentially right after the company is founded.
Traditional loans often aren't viable for raising this capital, given the lack of collateral, low creditworthiness, and high risk of default. As a result, many founders turn to venture capital investors for startup financing. In the earliest stages, these investors frequently provide funding through convertible loans.
What is a convertible loan?
A convertible loan is a financing instrument that sits between a standard loan agreement and equity financing.
Venture capital investors supply funds by granting a loan, but unlike a traditional loan, the expectation isn't that it will be repaid in cash. Instead, the loan amount converts into the company's shares, hence the term "convertible loan." Conversion typically happens during the next financing round, but it can also occur at the loan's maturity date or in an early exit.
When the invested capital is converted into shares, investors are usually granted a 5 to 20% discount on the share price in the associated financing round. This discount rewards convertible lenders for investing ahead of the round.
Advantages and disadvantages for founders and investors
A major advantage of convertible loans is that the agreement between lender and borrower is relatively straightforward compared to traditional financing documentation. That simplicity allows for quicker signing and lower transaction costs.
It also means the often difficult task of valuing the company, which founders and investors usually negotiate together, can be postponed until the next financing round.
That said, investors should be aware that convertible loans are typically unsecured and subordinated. If the startup becomes insolvent, the lender has no security and ranks behind all other creditors, effectively last in line. In this respect, a convertible loan is similar to equity.
Key terms for negotiation
When negotiating a convertible loan, founders and investors should discuss the following terms:
- Term of the convertible loan: How long the loan runs before it must convert or be repaid, often set to align with the expected next financing round.
- Interest rate (typically between 0.1% and 8%): The interest that accrues on the loan, usually added to the amount that converts into shares rather than paid out in cash.
- Discount on financing round and exit: The reduction on the share price the investor gets at conversion, rewarding them for investing early ahead of the round.
- Valuation cap: A ceiling on the company valuation used to convert the loan, protecting the investor's stake if the next round comes in at a much higher valuation.
- Conversion events: The defined triggers that turn the loan into shares, typically the next financing round, the maturity date, or an exit.
- Guarantees (in some cases): Assurances from the company or founders on specific facts or obligations, included in some deals to give the investor extra protection.
- Information rights: The investor's right to receive certain company information, such as financial updates, while the loan is outstanding.
How GAIA can help with convertible loans
As a GAIA user, you have access to a standard convertible loan template you can use directly. If you prefer, you can consult a lawyer from one of our partner law firms for a customized template or legal advice on your convertible loan. GAIA also helps you keep an overview of all your current convertible loans.
The most important contract terms, such as maturity date, interest rate, discount, and minimum valuation, are displayed clearly, so you always have the key terms at a glance. When the next financing round comes around, you can use our financing simulation to model your new cap table, including the conversion of the convertible loans.
