A few weeks ago we explained to you the different financing rounds that a startup must face throughout its life.
We also talked about what type of investors usually intervene in each of these rounds depending on the capital that the company needs.
Today, we want to talk to you about a form of financing that is very attractive for startups and investors, and whose popularity is growing due to the advantages it represents for both sides of the equation.
These are convertible loans, which are often widely used by Family, Fools and Friends in the initial stages of the company thanks to the flexibility and simplicity that this instrument provides.
Now we explain why.
Convertible loans are a form of credit in which an investor lends money to a startup in exchange for reserving the preferential right to convert the money contributed into equity in the future.
In this way, if the investor decides to execute that option due to the growth of the startup, he will become a shareholder with the same rights and obligations as any other partner.
And in the event that you are not interested in becoming a partner because the growth of the company has not been what you expected, you may choose to receive the loan repayment plus the associated interest.
This financing instrument is very flexible for both parties since the will of each is established by means of a commercial contract, in which the different options for converting the loan into capital are set.
Thus, the investor and the startup agree in advance what percentage of capital corresponds to the former if they decide to exercise the option to convert it into shares in the future.
This method of financing presents a double incentive for investors.
If the company does not achieve the expected results, they run a lower risk because they can recover their capital.
If, on the contrary, the company grows as expected, they make sure to take a position as one of the partners of the company.
On the other hand, this type of loan allows the startup to obtain financing much faster (and thus, attractive to investors) than a traditional investment.
This is because in the investment rounds there are many aspects that we must consider and that in a convertible loan they do not need to be taken into account. For example, the definition of control clauses or the negotiation of management positions.
Finally, it is important to emphasize that although this type of loan involves a certain sacrifice for the company in making decisions in favor of the investor, its costs are lower than a capital increase.
As with other financing instruments, there are many aspects that we must take into account if we want to use them for our startup.
Here we briefly explain some of them.
Convertible loans are part of the startup’s debt, so we must take that into account as long as they do not become equity capital in order to avoid possible financial imbalances.
The investor usually requests a discount on the premoney valuation of the company upon conversion given that the startup is in a very early stage and therefore must assume a greater risk than other subsequent investors.
Thus, if everything goes as expected and the company grows favorably, the investor will be able to achieve a higher percentage of shareholding in the future as compensation for the added risk.
It is essential to establish in the agreement between the parties when each of them can request the conversion or repayment of the loan, for example:
- When a certain period of time has elapsed since the signing of the agreement.
- When the startup has closed a new round of financing for a certain amount.
- When agreed between both parties.
Not leaving these conditions in writing could lead to many problems for the startup.
Something that we must put in writing are the conditions under which investors can be incorporated as partners in case of wanting to execute this conversion option in the future.
We must also assure them that they will have the same rights and obligations as the other partners if they become one of them.
We must decide whether we want the negotiation to take place individually or collectively.
If the agreement is negotiated individually, each investor will have their own particular conditions (interest rates, repayment terms, etc.).
In the event that the agreement is negotiated with several investors collectively, it will be necessary to draw up a loan that regulates all these conditions. Thus, each lender will contribute a different amount of money under the same conditions as the rest.
As you have just seen in this article, correctly structuring this type of loan is essential to protect the interests of both investors and your startup.
And since we know that it is not an easy task, you may be considering the option of receiving financial advice for it.
At The Startup CFO we help innovative startups and SMEs to obtain financing so that they grow faster and with greater confidence in the face of possible mistakes that they may commit due to lack of experience or knowledge. So if you have a startup in the initial phase and you need us to advise you on how you can finance yourself through convertible loans, we invite you to contact us.