Convertible Loans are bonds, shares, or other financial instruments that can be converted at a latter point by the shareholder into common stock.
Convertible loans have become a common way for startups to organise seed funding with some investors. Convertibles are a short-debt that convert into equity, most suitable for companies with a low credit rating but high growth potential – ie your startup!
A convertible loan is a bond with a fixed interest rate. Thus, they yield interest payments but can also be converted into a predetermined number of common stock or equity shares. It is once the loan matures that an investor can decide to convert the loan into shares or equity upon evaluation of your startup.
Convertible loans are attractive to investors because it provides a type of hybrid security that has features of a loan, such as interest payments, while also having the option to own common stock or equity shares. Hence, the investor enjoys the potential profit that can be made if your startup grows while being protected by the debt security offered.
When Does the Loan Mature?
Founders must not forget that a convertible loan, like most loans, has a fixed due date known as the maturity date; where the amount borrowed, plus interest, must be paid. When the loan will mature is agreed upon between the parties but generally has a duration of 12 to 24 months. The maturity date determines the deadline for the loan agreement to be automatically converted into equity. However, it may be decided in your investment offer that the investor upon maturity has a choice either to receive the debt security or take shares.
Benefits of Convertible Loans
Essentially, convertible loans are attractive because they are quicker, simpler and cheaper than other forms of investment. A convertible loan can be issued within a day or two by merely drafting a promissory note. Also financing for a convertible loan tends to be faster than priced rounds as there is no need to create a second class of shares, issue common stock or agree on a valuation of the startup.
Typically, these types of loans only give common stock preventing the investor from gaining the control rights that they would if they received preferred stock. On top of this, it is generally a flexible financing option and if the loan is converted to stocks then the debt owing vanishes.
A convertible loan often has a lower coupon rate or rate of return compared to a non-convertible debt. This lower rate is consideration for the value of the option to convert the bond into common stock.
Stock Dilution
However, a significant disadvantage of convertible loans is that the value of shareholder’s equity is reduced due to the stock dilution expected when bondholders convert their bonds into new shares. Stock dilution refers to the decrease of an existing stockholder’s ownership percentage of a company when that company issues new stock. This can become increasingly problematic when a company has been issued with many convertible loans.
The effects of stock dilution should be considered before agreeing to convertible loans.
Phil is a director at OpenLegal. He has over 16 years experience working in private practice and in-house counsel in Sydney and London, giving him expertise in employment law, IP, finance, leases, dispute resolution, insurance and contracts.
Raymond is a legal intern at OpenLegal, working with our legal content team. He is currently a penultimate student at the University of Technology Sydney, studying a Juris Doctor degree with an undergraduate Bachelor of Global Studies. He is particularly interested in Intellectual Property law and the increasing internationalisation of that area of business.
