Fundraising: convertible debt or straight to equity?

In the news, you can read about this and that start-up raising money or getting an investment. Rarely one stops to think what it actually means.

The basics of it are simple: the investor gives the company money and hopes to make a profit on the investment. There are two main ways a start-up raises money: convertible debt or an equity investment.

Straight-to-equity: a one-time payment grants shareholder rights

In case of an equity investment, the founders and existing shareholders sell a percentage of the company for a sum of money. In case of an equity investment, the investor transfers the money to the company and hopes that the company achieves an exit one day in the future and there is no set deadline for the investor to reap the rewards.

After investing in the company, the investor also becomes a shareholder of the company, so the investor has the possibility to directly influence the company’s development and business. As the investor’s ownership percentage is usually small, the investors are given special and preferential rights.

In most cases, liquidation preference is granted to the investor in preference to the founders and employee shareholders. This works as a guarantee to the investor that even if everything does not work out as hoped, the investor will at least not make a loss. Read more on liquidation preference here.

Furthermore, the investor is usually granted special rights when it comes to taking the central decisions of the company, such as dividend distribution, establishing subsidiaries, or making pivots. The investor may also be granted a seat at the supervisory board or an observer to board meetings, in addition to the general information rights.

So in the case of an equity investment, the investor makes the investment and will be involved in the company directly until the investor exits. However, there is no deadline and the investor will also share in the downside of the business.

Convertible loan: a less hands-on approach to investment

The convertible loan is a loan which upon the fulfillment of certain conditions can or will be converted into the share of the company at a future date. The convertible loan agreement includes the typical terms of a loan agreement: interest rate and maturity date.

Additionally, the convertible loan agreement includes provisions on the different conversion events, in most cases providing for a compulsory conversion upon a next equity financing exceeding a pre-agreed sum (this is called “Qualified financing”), conversion upon a liquidity event, and elective conversion upon the maturity date.

The convertible loan agreement may also include a discount and/or a valuation cap. These provisions work as the upside for the investor, allowing the investor to purchase shares at a lower price than the one paid by the investors in the later round.

In comparison to the equity investment, the convertible loan investor does not have any shareholder rights until the loan is converted into a share of the company, hence the convertible loan investor is not able to steer the company’s development directly. However, a convertible investor may reclaim its investment at the maturity date – something that the equity investor cannot do.

The convertible loan investment usually is easier to conduct from the legal side and can be completed faster and with lower costs than the equity investment. The upside of the convertible loan to the company is that they do not necessarily need to come up with a valuation for their company and can postpone this to the future by just offering a discount to the investors.

The devil is in the details and dependent on the circumstances

Whether to opt for equity investment or a convertible loan, depends on the circumstances. There are certain details to note in both cases and which suits your current needs at a certain point may not be transferrable to other situations or companies.

If you wish to discuss more on the options, please contact us.

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