Convertible loans: benefits, risks, and legal considerations for businesses and investors

Convertible loans are a unique and flexible financing tool that has gained popularity, especially among startups.

These loans blend the characteristics of debt and equity financing, offering a loan that can be converted into equity shares of the company at predetermined conditions.

The appeal of convertible loans lies in their ability to provide startups with the crucial capital they need while delaying valuation discussions until a later financing round.

This mechanism not only helps in reducing immediate financial pressures but also aligns the interests of investors and founders by focusing on company growth.

1. Use Cases of Convertible Loans

1.1 Financing Startups

Convertible loans are particularly supportive for early-stage companies. At a stage where a startup may not have a stable revenue stream or a clear valuation, traditional financing methods might not be feasible or attractive.

Convertible loans offer a solution by providing the necessary funds to fuel growth and reach key milestones.

The conversion feature is especially beneficial for startups, as it allows investors to convert their loans into equity at a later date, often during a significant funding round, based on the company’s performance and valuation at that time.

1.2. Bridge Financing

Convertible loans serve as an excellent tool for bridge financing, offering companies a temporary financial boost to navigate through short-term needs or until the next major financing event.

This use case is crucial for companies that are in the midst of transitioning from one funding round to another but require immediate capital to maintain momentum.

The flexibility and relatively straightforward terms of convertible loans make them an ideal choice for bridging finance gaps.

2. Legal Aspects of Convertible Loans

2.1. Prerequisites

Before diving into the complexities of convertible loan agreements, startups must ensure they meet certain prerequisites to facilitate a smooth and unambiguous process.

These foundational steps are critical in preparing a company for the eventual conversion of debt into equity, safeguarding against potential legal or operational obstacles. Key prerequisites include:

  • Adequate Share Capital: The company’s share capital must be sufficiently large to accommodate the conversion of the loan into equity. This ensures that when the time comes for conversion, the company can issue shares without facing limitations on its authorized share capital. Read more about the nuances of the company’s share capital here.
  • Articles of Association Adjustments: The company’s articles of association should be tailored to support the convertible loan process. This includes provisions for:
    • Payment in Non-monetary Contributions (mitterahaline sissemakse): Enabling the company to accept investments in forms other than cash, which is crucial for the conversion process.
    • Paying for Shares with Issue Premium (ülekurss): Allowing shares to be issued at a premium over the nominal value, which is necessary to convert the entire outstanding debt.
    • Preferred Shares: If applicable, the articles should detail the rights and preferences of different classes of shares, including any preferred shares that might be issued upon conversion.

2.2. Agreement regarding convertible instruments

To simplify the signing process, it may be beneficial to omit shareholders from the parties that sign the convertible loan agreement.

Startup Estonia’s model convertible loan agreement document also follows this principle.

However, in this case, the shareholders of the company ought to enter into an agreement regarding convertible instruments, in which they undertake to adopt necessary resolutions upon loan conversion, waive their pre-emptive right to acquire new shares to be issued upon conversion, and, if a new class of shares is to be created, to adopt a resolution to amend the articles of association of the company.

Attached to this agreement is also the template of the convertible loan agreement, containing all of the key terms (see below).

This agreement ought to be signed before signing any convertible loan agreements.

2.3. Key Terms

The key terms of a convertible loan agreement encompass several critical elements, such as loan, discount, interest rate, maturity date, and qualified financing threshold.

For those seeking clarity on these terms, the Startup Estonia model document for convertible loan agreements available here provides a comprehensive guide.

This document not only elucidates these critical elements but also offers insight into how they interplay within the broader context of startup financing strategies.

2.4. Conditions for Conversion

The conversion mechanism is a cornerstone of convertible loans, detailing the process and conditions under which the loan will be converted into equity. This typically occurs upon:

  • Qualified financing: raising financing for the company that exceeds the qualified financing threshold 
  • Liquidity event: voluntary dissolution of the company, sale of substantial assets, or change of control over the company
  • Maturity date: if the maturity date arrives without qualified financing having taken place, the loan shall be converted into shares of the company

In some instances, the loan and accrued interest may be paid back to the investor if the maturity date arrives without qualified financing having taken place. However, in most cases where the loan has not been converted by the maturity date, the company probably does not have the money to cover the repayment obligation and thus, conversion of the loan is favoured. A more thorough explanation on the key terms can be found here.

3. Advantages and Disadvantages of Convertible Loans

3.1. Advantages

Convertible loans offer flexibility and simplicity, making them an attractive option for both investors and entrepreneurs.

For startups, they provide an essential funding lifeline without the immediate need for a valuation, while investors benefit from the potential to convert their loans into equity at favourable terms.

This flexibility can lead to significant upside potential for investors if the company grows substantially.

3.2. Disadvantages

However, convertible loans are not without their risks and complications. The uncertainty of future valuation and the potential dilution of equity for existing shareholders can be points of contention.

Additionally, the terms of conversion and the valuation caps involved can lead to complex negotiations and require careful consideration to ensure they align with the long-term goals of the company and its investors.

4. Alternatives to Convertible Loans

Alternatives to convertible loan agreements include Simple Agreements for Future Equity (SAFEs) and traditional investment agreements for seed investments. Each of these options has its unique features, benefits, and drawbacks, tailored to different startup needs and investor preferences.

4.1. Simple Agreements for Future Equity (SAFEs)

SAFEs are a popular alternative to convertible loans, especially in the startup ecosystem.

Created by Y Combinator, SAFEs are investment contracts that allow investors to convert their investments into equity at a future date, typically at a discount and following a valuation event like a financing round.

Unlike convertible loans, SAFEs are not debt instruments and do not accrue interest, making them a simpler and potentially more founder-friendly option.

SAFEs offer simplicity and avoid the accrual of interest, potentially making them more favourable for startups.

However, the lack of a maturity date can be a double-edged sword, providing flexibility but also uncertainty regarding conversion timing. Convertible loans, with their debt-like features, impose a more structured timeline but introduce interest and potential repayment obligations.

4.2. Cash Investments

Equity investment agreements are formal equity financing arrangements used during a startup’s initial funding phase. These agreements involve a direct exchange of capital for equity, requiring a valuation of the company.

Though potentially more complex and time-consuming due to the valuation process, equity investment agreements offer a clear equity stake and dilution rate from the outset, providing both parties with immediate clarity regarding ownership and control.

While equity investment agreements provide immediate equity and clear ownership structures, they require early valuation, which can be challenging and potentially disadvantageous for startups in their nascent stages.

The clarity and stability of equity investments, however, may be more attractive to certain investors and founders seeking straightforward, long-term partnerships. You can read more about the differences between cash investments and convertible loans from our article.

5. Conclusion

The decision between using a convertible loan, SAFE, or an equity investment agreement depends on various factors, including the startup’s financial health, growth trajectory, and the strategic goals of both the company and its investors.

Startups may prefer SAFEs for their simplicity and founder-friendly terms, whereas investors might lean towards convertible loans for their structured approach and interest accrual. Equity investment agreements stand out for those valuing immediate equity clarity and willing to undertake early valuation.

Overall, convertible loans represent a critical instrument in the financing landscape for startups, offering a bridge between debt and equity financing that suits the dynamic needs of fast-growing companies.

While they come with a unique set of advantages and considerations, their flexibility and potential for alignment between founders and investors make them a popular choice in the venture capital ecosystem.

If you are looking to know more about convertible loans or financing in general, Hedman’s lawyers are here to help. Get in touch with us!

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