A convertible loan (aka convertible note or convertible debt) is a startup’s best friend, or worst nightmare, depending on how you play it. It starts as a loan but can flip into equity, usually during a funding round. This chameleon-like financing is a go-to for early-stage investors and founders because it mixes the safety of debt with the upside of ownership.
So, is it a genius move or a risky gamble? Let’s break it down.
What is a convertible loan?
A convertible loan is a short-term debt that converts into equity when certain conditions like a funding round are met. The conversion terms often include a discount or valuation cap, giving investors a sweet deal on shares.
🔑 Key takeaway: A convertible loan is flexible funding that shifts from debt to equity, keeping startups nimble and investors happy.
How does a convertible loan work?
Loan agreement:
An investor lends money to a startup, agreeing on terms like interest rate, maturity, and conversion triggers.
Conversion:
During a future funding round, the loan converts to equity, typically at a discount or with a valuation cap.
Equity ownership:
The investor becomes a shareholder, owning a stake in the company based on the conversion terms.
What makes a convertible loan special?
Debt turns into equity:
When a startup raises funds, the loan converts into shares based on pre-agreed terms.
Interest builds up:
If not converted quickly, interest accrues, impacting the final conversion price.
Maturity date matters:
If conversion doesn’t happen in time, the startup may need to pay back the loan.
Discounts & valuation caps:
Investors often get perks like discounted shares or caps on valuation, maximizing their returns.
Benefits of a convertible loan
For startups:
Quick cash, no valuation hassles. Startups don’t always have a clear valuation, and that’s okay. A convertible loan gets funding fast while pushing the valuation talk down the road.
For investors:
Low risk, high reward - lend now, convert later. If the startup takes off, investors snag equity at a bargain.
Simple deal structure:
Skip the endless valuation debates. A convertible loan is faster, easier, and avoids all the back-and-forth.
Flexibility in uncertain markets:
Deferring valuation decisions can be a lifesaver in unpredictable economies.
Risks of convertible loans
Over-dilution for founders: Too many convertible loans = less ownership for early investors and founders.
Cost can be misleading:
The interest cost of the convertible loan is part of the cost, the other cost is the discount on the next equity round.
Valuation uncertainty for investors:
If the company underperforms, equity conversion might not be as sweet as expected.
Maturity date pressure:
If conversion doesn’t happen, startups must pay up.
Messy cap tables:
Multiple convertible loans can complicate future fundraising rounds.
How to use convertible loans like a pro
For startups:
- Lock in favorable terms (discounts, caps, deadlines) that align with your growth strategy.
- Keep an eye on dilution, too many convertible loans can chip away at your ownership.
- When calculating the cost of a convertible loan, make sure to add the cost of the equity conversion on top of the interest rate you are paying
- Be prepared to pay back if conversion doesn’t happen.
- Check if you need a shareholder vote before issuing a convertible loan (laws and company structures vary).
For investors:
- Analyze the startup’s potential before committing.
- Understand the fine print - valuation caps and discounts impact your returns.
- Diversify your investments to manage risk.
- Compare convertible loans vs. convertible bonds to make sure you're getting the best deal.
For both:
- Get legal and financial experts to review agreements.
- Communicate clearly about conversion timelines and expectations.
- Identify risk-mitigation strategies to protect your interests
The convertible loan cheat sheet
Example of a convertible loan in action
🚀 Startup X takes a $500,000 convertible loan from Investor Y.
- The loan has a 20% discount and a $5M valuation cap.
- A year later, Startup X raises a Series A at a $10M valuation.
- Investor Y’s loan converts at $5M valuation (thanks to the cap) with an extra 20% discount.
🎯Result: Investor Y gets way more shares than new investors putting in the same amount in Series A.
FAQs
- What’s the difference between a convertible loan and a convertible bond?
Both instruments are similar, but the key difference is that convertible bonds, which are typically traded on public markets, are more standardized and suited for larger public companies. In contrast, convertible loans offer more flexibility and are commonly used by early stage startups. - What is a valuation cap?
A valuation cap sets a maximum company valuation for conversion. It protects investors by ensuring they get equity at a fair price, even if the startup skyrockets. - What happens if a convertible loan doesn’t convert?
The startup must repay the loan, including any accrued interest, by the maturity date, potentially a big financial burden.
To wrap up
A convertible loan is a powerful tool for startups that need capital and investors chasing big wins. But it comes with risks like dilution, interest accumulation, valuation uncertainty, and legal complexities. Understanding these trade-offs helps both sides make smarter moves.
Want more smart funding moves? At Float, we redefine funding for SaaS businesses with more favorable terms for founders. Let’s chat
