Convertible Loans: What to Know and How They Work
By David Papier
A convertible promissory note is a debt security that converts into equity when certain conversion events occur. Unlike an equity investment where an investor receives a stake in the company in exchange for cash, an investor who provides a convertible loan instead will provide a loan that has a maturity date, interest and the right to convert the loan into equity at some point in the future.
A convertible loan has certain significant advantages as compared to an equity investment:
- Faster, Cheaper Process. Since it is a fairly short and simple document, a convertible loan gets executed and processed much faster and cheaper than an equity investment.
- Senior to other Equity. Convertible promissory notes are senior to other equity and noteholders will have a priority right at maturity to claim any assets.
Defers Established Valuation. Issuing convertible notes do not force the company and the investor to determine the value of the company.
- Less Rights Afforded to Noteholders. Typically the noteholder does not have the many rights afforded to an investor in an equity investment (liquidation preferences, board seats, etc.).
Typical terms which can be found in a convertible loan include:
- Maturity Date. The date on which the loan matures (at which time the company needs to repay the loan). This date is often established 1 to 2 years from the issuance date to allow the company to consummate a preferred stock financing into which the promissory note converts, while affording the investor a certain “downside” protection to recoup the investor’s investment with interest at maturity.
- Interest. Standard convertible loans do not require an immediate payment of interest, as interest typically accrues to the principal and is payable at conversion or on maturity. Interest rates are often between 5-8%, albeit recent trends are now reflecting more nominal rates.
- Conversion. The loan mandatorily converts into equity in conjunction with a future financing round that involves a certain threshold amount of money. Such threshold provides certain comfort to noteholders that they are giving up their debt instrument at a time in which the company has reached a more healthy and sustainable status. Typically, the loan converts into equity with a conversion discount in valuation that is lower than the price paid by the investors purchasing shares in the financing to compensate the note holder for bearing the risk of investment prior to the financing. A typical discount is often between 10-30%.
In addition to a conversion discount, convertible loans may also include a valuation cap, which imposes a maximum valuation at which the loan will convert. It effectively places a limit on the value of the company so that the loan converts at no more than the agreed upon cap. It can provide significant equity-like upside if the company materially appreciates by affording the investor with a larger stake in the company. While a cap is not a “valuation”, it can be construed as a proxy for valuation. Thus, many companies will seek to avoid granting valuation caps in convertible loans.
A corporate transaction, such as a sale of the company, may also trigger conversion of the note. If neither a sale of the company nor a qualified financing occurs prior to maturity, the noteholder also often has the option of either converting the promissory note into shares of common or preferred stock or leaving the note outstanding.
Convertible loans involve less documentation and do not require a valuation of the company because the promissory notes are debt securities. Thus, if used correctly, convertible notes can be an effective, quicker and less costly alternative than equity investment to early-stage companies.