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The Convertible Loan

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Barry Schuman
Barry Schuman

The document discusses convertible loans as a hybrid form of financing that provides advantages of both debt and equity for startups. A convertible loan functions as a short-term loan that converts to equity ownership in the company upon a future financing event, like a Series A round. This protects early investors to some degree while allowing startups to avoid repaying the loan in cash. The document provides an example of how the conversion price is calculated using either a discount or valuation cap mechanism. Convertible loans are lower risk than straight equity but startup investments inherently carry risk.

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Schuman & Co. Law Offices ‫ושות‬ ‫שומן‬'‫ונוטריון‬ ‫דין‬ ‫עורכי‬ ‫משרד‬ http://www.schumanlaw.co.il/ 1 The Convertible Loan There are generally two ways that a startup can raise funding. The first is through equity; the second is debt. The Funding Dilemma Startups typically don’t have a credit history or assets which can be used as security against a loan, which makes securing a traditional loan from a conventional lender difficult and complicated. A company that’s in its early stages of formation will usually try to fund their initial operations with equity. However, in order to sell equity, you need to know the company’s valuation. Since figuring out a startup’s value is unclear due to the fact that it’s just starting up and typically doesn’t have any value (no assets, revenue or customers), determining a company's pre-money valuation is arbitrary. Furthermore, although the moral of a startup may be high, the likelihood of success may rather modest. As of result, investing in a startup is a high risk (the reward is also high risk, but not inevitable). In the event a startup is unsuccessful and must be liquidated, the shareholders are generally the last in line to receive all or a part of their investment back after the company liquidates its assets, if any. Debt holders, on the other hand, are usually one of the first parties to receive their investment back upon liquidation, certainly before the shareholders. In summary, the positive aspect of an equity investment is that startups prefer them due to the difficultly in receiving a loan and paying it back in cash. The positive aspect of a debt investment is that upon liquidation, the debtholders are one of the first parties to receive their investment back from the company's assets. The Solution In order to receive the positives of both an equity and debt investment at the same time, while mitigating the negative risks associated with those types of investments, a hybrid investment has been pioneered and is one of the primary forms of financing for startups: the Convertible Loan. A convertible loan is a loan from an early investor (angels or VCs). That investor expects that at some point later down the road (e.g., 1-2 years), the debt will convert into equity ownership in the company. Key Features
Schuman & Co. Law Offices ‫ושות‬ ‫שומן‬'‫ונוטריון‬ ‫דין‬ ‫עורכי‬ ‫משרד‬ http://www.schumanlaw.co.il/ 2 What distinguishes a convertible loan from an ordinary loan are two key characteristics: the discount and the valuation cap. The discount is a feature that rewards early investors for taking larger risks than later investors. It does this by offering the right to obtain shares at a cheaper price than that paid by Series A investors, once the Series A round closes. The conversion cap similarly rewards early investors for their disproportionate risk, but in a different way than the discount. The cap sets the maximum value of a company when Series A closes, again giving an advantage to earlier investors. Similar to ordinary loans, convertible loans contain an issuance date, interest rate and maturity date. Unlike conventional loans, repayment is with equity, not with cash. The discount and cap are features that offer early investors two different ways to value their original investment (loan) when the Series A round closes with a concrete valuation. One method will usually give the investor a higher rate of return than the other. This is why convertible debt terms usually provide that the early investor has the option (after qualifying financing is received at the Series A round), to choose between the lower of either the discount or cap conversion. Though it sounds contradictory, it’s actually the conversion price that’s the lower of the two methods that results in more shares issued to the early investor upon conversion. A Common Example Many founders are often perplexed about how convertible debt works, so we’ll work with a simple example. We’ll assume the Company wants to raise an initial $250,000. Founder and investor draft a convertible note for $250K, with a 20% discount or a $3 million cap, convertible upon the closing of a Series A round. The Discount The 20% discount means that the investor can buy the stock concurrent with the Series A investment round closing at a price per share equal to 20% less than what Series A investors can buy it for. If the share price for the Series A round is set at $1.00 per share, the discount would enable the debt holder to buy the same shares at $0.80 per share. The equation is as follows: the investment amount divided by the discounted price. So using the above variables, it’s $250,000 divided by $0.80, which gives our early investor 312,500 shares. Remember, the shares were purchased at a discount of $0.80, however their true price is $1.00. Therefore 312,500 multiplied by $1.00 is equal to $312,500. The investor received shares worth $312,500. This translates into a 1.25X return, which you get by dividing the value of the number of shares received by the original investment: $312,500 divided by $250,000 equals 1.25. The debt investor essentially achieved a 25% return on his investment.
Schuman & Co. Law Offices ‫ושות‬ ‫שומן‬'‫ונוטריון‬ ‫דין‬ ‫עורכי‬ ‫משרד‬ http://www.schumanlaw.co.il/ 3 The Cap Now we’ll assume that the Series A round is at a pre-money valuation of $5 million. The way we calculate the cost per share upon the conversion) using the cap valuation method is by dividing the company valuation cap set for the debtholder by the Series A round pre-money valuation used: $3,000,000 (the debtholder cap) divided by $5,000,000 (the Series A valuation) = $0.60 per share. Next, we take the $250K loan amount and divide it by the $0.60 price per share. $250,000 divided by $0.60 = 416,666 shares. The debtholder receives 416,666, which is 166,666 more shares than the Series A investors would receive for the equivalent investment of $250K at a $5M pre-money valuation. This translates into a 67% return on investment for the debtholder. Summary A convertible loan is a short-term debt instrument that converts into equity. Usually it converts upon the closing of the next financing round. The advantage from the perspective of a company is that a convertible loan before its conversion behaves very much like a standard loan: the investor typically does not have many of the rights of a shareholder (board seats, right to dividends, liquidation preferences, etc.). Furthermore, upon conversion the company grants the debt holder equity in the company and does not have to pay through cash which is often hard to come by for an early stage company without consistent revenue. The disadvantage comes from the very nature of the loan: if the loan is to be converted upon the closing of another financing round, and the company is unsuccessful in doing so, the investor has the right to be repaid the loan amount, including interest accrued. However, startups don’t have enough cash to repay the loan at maturity and thus in order to repay the loan and interest accrued the company may be forced to liquidate its assets and declare bankruptcy. Convertible loans are lower risk to investors than a straight forward equity investment. However, startup investments are, in the majority of cases, inherently risky and the main attractive reason for using a convertible loan is often the speed with which it can be put in place. This document provides a general summary and is for information purposes only. It is not intended to be comprehensive nor does it constitute legal advice. If you are interested in obtaining further information please contact our office at: Schuman & Co. Law Offices Beit Bynet, 8 Hamarpe Street, P.O.Box 45392 Har Hotzvim, Jerusalem 97774 Israel Tel: +972-2-581-3760, Fax: +972-2-581-5432 Schuman@schumanlaw.co.il http://www.schumanlaw.co.il/

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The Convertible Loan

  • 1. Schuman & Co. Law Offices ‫ושות‬ ‫שומן‬'‫ונוטריון‬ ‫דין‬ ‫עורכי‬ ‫משרד‬ http://www.schumanlaw.co.il/ 1 The Convertible Loan There are generally two ways that a startup can raise funding. The first is through equity; the second is debt. The Funding Dilemma Startups typically don’t have a credit history or assets which can be used as security against a loan, which makes securing a traditional loan from a conventional lender difficult and complicated. A company that’s in its early stages of formation will usually try to fund their initial operations with equity. However, in order to sell equity, you need to know the company’s valuation. Since figuring out a startup’s value is unclear due to the fact that it’s just starting up and typically doesn’t have any value (no assets, revenue or customers), determining a company's pre-money valuation is arbitrary. Furthermore, although the moral of a startup may be high, the likelihood of success may rather modest. As of result, investing in a startup is a high risk (the reward is also high risk, but not inevitable). In the event a startup is unsuccessful and must be liquidated, the shareholders are generally the last in line to receive all or a part of their investment back after the company liquidates its assets, if any. Debt holders, on the other hand, are usually one of the first parties to receive their investment back upon liquidation, certainly before the shareholders. In summary, the positive aspect of an equity investment is that startups prefer them due to the difficultly in receiving a loan and paying it back in cash. The positive aspect of a debt investment is that upon liquidation, the debtholders are one of the first parties to receive their investment back from the company's assets. The Solution In order to receive the positives of both an equity and debt investment at the same time, while mitigating the negative risks associated with those types of investments, a hybrid investment has been pioneered and is one of the primary forms of financing for startups: the Convertible Loan. A convertible loan is a loan from an early investor (angels or VCs). That investor expects that at some point later down the road (e.g., 1-2 years), the debt will convert into equity ownership in the company. Key Features
  • 2. Schuman & Co. Law Offices ‫ושות‬ ‫שומן‬'‫ונוטריון‬ ‫דין‬ ‫עורכי‬ ‫משרד‬ http://www.schumanlaw.co.il/ 2 What distinguishes a convertible loan from an ordinary loan are two key characteristics: the discount and the valuation cap. The discount is a feature that rewards early investors for taking larger risks than later investors. It does this by offering the right to obtain shares at a cheaper price than that paid by Series A investors, once the Series A round closes. The conversion cap similarly rewards early investors for their disproportionate risk, but in a different way than the discount. The cap sets the maximum value of a company when Series A closes, again giving an advantage to earlier investors. Similar to ordinary loans, convertible loans contain an issuance date, interest rate and maturity date. Unlike conventional loans, repayment is with equity, not with cash. The discount and cap are features that offer early investors two different ways to value their original investment (loan) when the Series A round closes with a concrete valuation. One method will usually give the investor a higher rate of return than the other. This is why convertible debt terms usually provide that the early investor has the option (after qualifying financing is received at the Series A round), to choose between the lower of either the discount or cap conversion. Though it sounds contradictory, it’s actually the conversion price that’s the lower of the two methods that results in more shares issued to the early investor upon conversion. A Common Example Many founders are often perplexed about how convertible debt works, so we’ll work with a simple example. We’ll assume the Company wants to raise an initial $250,000. Founder and investor draft a convertible note for $250K, with a 20% discount or a $3 million cap, convertible upon the closing of a Series A round. The Discount The 20% discount means that the investor can buy the stock concurrent with the Series A investment round closing at a price per share equal to 20% less than what Series A investors can buy it for. If the share price for the Series A round is set at $1.00 per share, the discount would enable the debt holder to buy the same shares at $0.80 per share. The equation is as follows: the investment amount divided by the discounted price. So using the above variables, it’s $250,000 divided by $0.80, which gives our early investor 312,500 shares. Remember, the shares were purchased at a discount of $0.80, however their true price is $1.00. Therefore 312,500 multiplied by $1.00 is equal to $312,500. The investor received shares worth $312,500. This translates into a 1.25X return, which you get by dividing the value of the number of shares received by the original investment: $312,500 divided by $250,000 equals 1.25. The debt investor essentially achieved a 25% return on his investment.
  • 3. Schuman & Co. Law Offices ‫ושות‬ ‫שומן‬'‫ונוטריון‬ ‫דין‬ ‫עורכי‬ ‫משרד‬ http://www.schumanlaw.co.il/ 3 The Cap Now we’ll assume that the Series A round is at a pre-money valuation of $5 million. The way we calculate the cost per share upon the conversion) using the cap valuation method is by dividing the company valuation cap set for the debtholder by the Series A round pre-money valuation used: $3,000,000 (the debtholder cap) divided by $5,000,000 (the Series A valuation) = $0.60 per share. Next, we take the $250K loan amount and divide it by the $0.60 price per share. $250,000 divided by $0.60 = 416,666 shares. The debtholder receives 416,666, which is 166,666 more shares than the Series A investors would receive for the equivalent investment of $250K at a $5M pre-money valuation. This translates into a 67% return on investment for the debtholder. Summary A convertible loan is a short-term debt instrument that converts into equity. Usually it converts upon the closing of the next financing round. The advantage from the perspective of a company is that a convertible loan before its conversion behaves very much like a standard loan: the investor typically does not have many of the rights of a shareholder (board seats, right to dividends, liquidation preferences, etc.). Furthermore, upon conversion the company grants the debt holder equity in the company and does not have to pay through cash which is often hard to come by for an early stage company without consistent revenue. The disadvantage comes from the very nature of the loan: if the loan is to be converted upon the closing of another financing round, and the company is unsuccessful in doing so, the investor has the right to be repaid the loan amount, including interest accrued. However, startups don’t have enough cash to repay the loan at maturity and thus in order to repay the loan and interest accrued the company may be forced to liquidate its assets and declare bankruptcy. Convertible loans are lower risk to investors than a straight forward equity investment. However, startup investments are, in the majority of cases, inherently risky and the main attractive reason for using a convertible loan is often the speed with which it can be put in place. This document provides a general summary and is for information purposes only. It is not intended to be comprehensive nor does it constitute legal advice. If you are interested in obtaining further information please contact our office at: Schuman & Co. Law Offices Beit Bynet, 8 Hamarpe Street, P.O.Box 45392 Har Hotzvim, Jerusalem 97774 Israel Tel: +972-2-581-3760, Fax: +972-2-581-5432 Schuman@schumanlaw.co.il http://www.schumanlaw.co.il/