A convertible loan is a type of financing where companies are given a loan to be repaid or, in most scenarios, to be converted into equity at a future date. Convertible loans generally take less time than equity funding which is primarily expensive and time-consuming to acquire. Therefore, convertible loans allow quick access to cash not only in the diagnostic, digital health, precision medicine, and life science tool industry.
Discount Rate
This is a valuation discount the investor receives relative the valuation in the subsequent financing round, compensating for the additional risk taken on by investing earlier.
Valuation Cap
Protects the loan investor if a sudden increase in the investee company’s valuation. The convertible loan will still convert to shares upon the trigger event, either the agreed date or the qualifying round. However, the conversion price will depend on the valuation cap.
Interest Rate
Since the investor is lending money to a company, convertible notes will more often than not accrue interest as well. However, as opposed to being paid back in cash, this interest accrues to the principal invested, increasing the number of shares issued upon conversion.
Maturity Date
For the loan to be converted into equity shares, the investor and the investee company must first negotiate the trigger for the conversion of the loan. They can either agree on a specific date or a qualifying period of equity conversion. Some of the other vital factors that can trigger the conversion include change of control, liquidation or sale of the investee company, and default.
Key Pros and Cons of convertible loans
Convertible loans have plenty of noticeable benefits for both sides. It’s upon the investors to analyze the possible risk before betting their money on one company and upon the startup representative do decide on terms, they feel comfortable with. Here are some of the pros and cons of convertible loans:
Pros of convertible loans
- Have a lower risk and are efficient.
- Pre-valuation investment.
- Convertible loans have simpler documentation.
- Decisive power remains with the founders.
Cons of convertible loans
- Risk of downfall
- Stringent indenture provisions
It’s upon every Startup founder to evaluate the investment required and its consequences before betting on investor money. Like any other investment convertible loans do have both advantages and disadvantages. Depending on your company’s goal and strategy it’s on you to decide whether this is the right path for you. However, convertible loans are common practice and very beneficial for startups looking for funding. It’s a great way to jump-start amazing innovation from early-stage startups, like we intend to with 42PLUS1.