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 does one stop to think about what it means.

The basics 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 the case of an equity investment, the founders and existing shareholders sell a percentage of the company for a sum of money. In the 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, so the investor can directly influence the company’s development and business. As the investor’s ownership percentage is usually tiny, 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 guarantees 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 on the supervisory board or an observer to board meetings, in addition to the general information rights.

So, in 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

A convertible loan is a loan that, upon fulfilling certain conditions, can or will be converted into the company’s share 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 subsequent equity financing exceeding a pre-agreed sum (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.

Compared 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 cannot steer the company’s development directly. However, a convertible investor may reclaim its investment at the maturity date – something 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. They can postpone this to the future by offering investors a discount.

The devil is in the details and dependent on the circumstances

The circumstances depend on whether to opt for equity investment or a convertible loan. Certain details to note in both cases suit your current needs at a certain point and 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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