The Convertible for startups explained

The Convertible explained for startups

In terms of transparency, openness and cooperation, it was our goal to provide both entrepreneurs and investors with a well prepared convertible loan term sheet and clean standards.


We and our investors believe in a positive and long relationship with the start-ups and mutual support. Our standard convertible loan term sheet and the contract based on it reflect this idea and are fair, so that neither investors nor start-ups are overly favoured. The ultimate goal is to uphold primeCROWD's quality standards, to reach a consensus quickly, and to conclude a deal promptly and, above all, with a minimum of resources and time.


Convertible loans basically work as follows: The investor (convertible lender) grants a loan to a company (convertible borrower). This loan is later converted into shares (or repaid) at a predefined event - most commonly: financing round, exit or maturity.


The logic behind this is that there is a more reliable and less speculative valuation of the company at these times rather than at the time of signing the convertible.

Convertible Loan

When loans are granted, occasionally valuation rules are either unclear, not thought through or agreed upon inaccurately. If there is then a conversion discussion, the company valuation has to be discussed extensively. It can be particularly unpleasant if the lender wants to achieve as low a valuation as possible in order to obtain as many shares as possible as loan equivalent, while the company strives for an adequately high valuation in connection with the acquisition of further investors. This conflict of interest must be avoided in the interest of all and contract negotiations should therefore be conducted not only between the lender and borrower, but also with the shareholders/founders of the borrower (e.g. with regard to the regulations for the later conversion of the loan into equity). However, most often the main driver to use a convertible is not valuation discussion but timing.


In order to simplify discussions and negotiations, primeCROWD has developed a standard that serves as a basis for a fair and understandable convertible.

General Info, Advantages and disadvantages of convertible loans


A convertible is considered mezzanine capital. It can sometimes (Depending on the structure) be classified as debt or equity. In our opinion, a convertible should be structured as equity, as this is what investors and startup alike ultimately want it to be (Additionally, this also has some advantageous tax implications in e.g. Austria or Germany). In order for a convertible to be considered equity, the most important aspect is that it should at any point of conversion (e.g. exit, maturity or qualified financing round) convert into equity, without an option or choice for it to be paid back at all (in parts or fully).

Lender / Investor Perspective

The Lender does not have the same participation rights as with a real participation. He is danger that in the context of the forthcoming financing round he will have his special rights, which have only been agreed under the law of obligations, will be negotiated away. The lender will therefore ensure that the conversion of the convertible loan into equity happens at fixed conditions. In such a case, the advantages and disadvantages for him are roughly as follows:


Advantages

o   Repayment of capital possible (but not standard) 

o   Interest

o   Valuation may be advantageous and discountable

o   Flexible design

o   Low transaction costs (time, costs, etc.) and quick investments

o   Clean Cap Table

o   Mezzanine: between equity and credit in terms of payout structure until conversion


Disadvantages

o   No shareholder status (no voting rights, only information rights)

o   Legal position weaker than participation

o   Contract clauses must be compared with participation contracts

o   In Germany, taxes might be / are due on conversion

Start-up Perspective

If necessary, not the possibility of triggering the conversion itself (bad for the financing attractiveness of the start-up) - clear restriction and bad for attracting further investors. Ideal for start-ups is the possibility of triggering the conversion themselves, e.g. by means of a conversion obligation. Advantages and disadvantages of convertible loans for start-ups:


Advantages

o   Not giving away ownership initially (at a low valuation)

o   Less complicated to handle (quicker)

o   No voting rights for investors 

o   ”Open” valuation

o   Flexible design

o   Low transaction costs (time, costs, etc.)

o   No seats on advisory boards that go along with it

o   Clean Cap Table


Disadvantages

o   No new shareholders

o   Repayment claims and interest may burden liquidity

o   If development is not according to plan, disposal of possibly more shares than planned

o   Contract clauses must be matched with participation contract

o   Financing capability may be restricted

o   Potential conflict of interest of convertible holders vs new investors

In practise, we have observed three main use cases of convertibles


As a substitute for a qualified Equity financing round

o   Postponing the administrative overhead into the future

o   The use case we use as basis for our standard


Classical bridge round

The essential goal here is to plan for a future round; terms are mostly in favour of the startup, that’s why these classical convertibles during bridge rounds are normally not attractive to investors. Startups that are super-hot and have a lot of demand for their investment round might be able to get away with this.  But that’s the exception, not the rule – investors have the same risk, but with a limited upside.


During an equity round

In case of an oversubscription of the round as a means of binding potential investors to the startup now.

 

As always, the devil is in the details and the differences between these use cases lie in the various form of conversion right or forced conversion, calculation methods (Dilution), Floors/Caps (Valuation bands), fixed and floating valuations, discounts, governance rights, …

The typical terms of convertible loans explained based on our standard convertible


Convertible loan basic information

o    Total amount of convertible loan capital: Serves to inform lenders and qualified investors of the total amount of convertible loans. Including any sweat equity interest.

o    Serial vs. single convertible: Important consideration for the structure of a convertible. We strive to design all convertibles as serial convertibles in case we need to to a subsequent bridge round. 

o    Duration: What is the duration of the loan?

o    Due date: "Maturity

      - Either conversion by investors (one-sided "call option") or fixed conversion

      - Or by mutual agreement: Extension of the convertible loan

o    Subordination: Convertible loans are usually structured as qualified subordinated loans, which means that, although they have a higher priority than equity capital, they are subordinated to "genuine" debt capital.

o    Cancelation: Possible for any important reasons 

o    Rights and obligations: The lender receives pari passu the same rights and obligations as all other investors (according to the Shareholder/participation agreement in existence / to be concluded then). Here it is important for startups to pay attention to liquidation preference (Since convertible lenders get the same as new investors)


Interest

Indicates the interest rate of the loan and can theoretically be also 0%. Interest rates should generally be higher than bank loans (higher risk), but lower than equity.

Standard: Interest is not paid out but converted into equity at the time of conversion (thus no cash flow burden on the start-up).


Conversion

1. Conversion at next financing round

Since a convertible loan is often seen as "bridge financing" (either to bridge cash flow bottlenecks as a "bridge" into the future where more information about the company will be available), the objective (and standard) is to convert the loan into equity at the next qualifying round of financing.


You can and should already determine when you plan to carry out the next round (based on the runway rate) and how much capital will be raised (based on the burn-rate).


Due to the increased risk that lenders take on (bridge financing or early stage), it is standard for convertible loans to give a discount on the then applicable pre-money valuation of approx. 10% - 30%. This means for startups that the future valuation can be higher than the cap, but due to the discount it is lower than the cap: e.g.: €4M cap and 20% discount, the cap is only advantageous for the investor with a valuation of over €5M (20% viscount of €5M = €4M) - each valuation below €5M brings the investor as many shares as if the loan had no cap.


Furthermore, cap and floor can be defined, i.e. maximum and minimum valuations of the company:


      o    Cap = investor-friendly

      o    Floor = Startup-friendly (rather unusual)


This will result in a valuation corridor within which an approximate valuation can move. We recommend (for investors) always to install a cap. Some convertible notes don’t have a cap at all, which means the sky is the limit on future valuation when the note converts. So at what level would one set the cap? That depends (amongst many other factors) highly on previous investments, hotness of the startup and market, traction, growth rates and KPIs, captable and shareholder structure. Obviously, investors want low caps, however we recommend a fair cap, in order for it to not sabotage or hinder any future rounds. Savvy and experienced investors will understand this. 


Due to caps and discounts, convertible loans can sometimes behave like full ratchets (in the event of an unfavorable development of the start-up). Entrepreneurs should work in our opinion growth-optimized and not dilution-optimized and since many things can happen it is recommended to pay special attention with regards to convertible loans when it comes to dilution and Captable evolution.


2. Conversion on Exit / Change of Control

In the event of a change of control (primarily sale of more than 50% of the shares, merger or complete sale of the IP, software or other fixed assets to third parties (asset deal), a right to conversion (with 20% discount or cap) or optionally repayment of the 2-3-fold amount of the loan (including outstanding interest) exists.


3. Conversion at Maturity

Should neither a financing round nor an exit have occurred at the time of the maturity of the loan, the loan can be converted including all interest or is being paid back. However, an extension may also be decided here. In the event of conversion at Maturity, a pre-money company valuation is usually given in advance (normally around 50% - 60% of the cap). A kind of downside, worst case commission for convertible lenders, should the startup not be able to raise capital.


Calculation methods

For the calculation of the convertible loans some methods and options can be considered, all of them are slightly different, depending on the round itself and the following considerations:

o   Founder friendly vs. convertible vs. Investors friendly?

o   What is the relationship between convertible lenders, qualified investors and founders?

o   How are shares of convertible lenders and qualified investors calculated?

o   What’s the use case for the convertible and when will be converted (During a round, at maturity, etc..)


Possible options for the calculation here are – exemplary for a classical convertible (no fixed valuation) with discount for a next round:


"Percentage" method

Most advantageous for the qualified investor because only the founders are diluted by the convertible lender. He wants to get a share for his investment as if there were no convertible loans outstanding. The post-money valuation without convertible loans reduced by the discount is used to calculate the share of the lender:


"Euros-Invested" method

Fair "compromise" (our standard) where all shareholders dilute each other (pre-money valuation + qualified investment + convertible). This (total) post-money valuation is used to calculate the convertible loan holder:


Syndication

Especially important for follow-up financing and revision of captables. Benefits: Risk minimization, increases investment power and business influence, prevents fragmentation, better transferability of investors shares and better for follow-up financing.


We see certain developments in this area with a crying eye and as such absolutely insist on pooling. Particularly on the investor side: If founders have to spend 30% of their time on investor relations because 10 Business Angels are not willing to invest syndicated into a company, it is toxic for the start-up, cause the time is missing to focus on technological & operational advancements.


Information rights

The lender, as a future GmbH shareholder, is naturally entitled to a general right to information from the company, which he would not otherwise have as a lender.

The primeCROWD Standard - an example


Albeit smaller convertibles (below 100k) are often used at the start of company, larger convertibles shouldn’t be a used for a first round, as investors don’t have the governance rights and other terms a savvy investor would usually demand for any larger capital being deployed. So here we try to give the lender an as much as possible synthetically re-created shareholder position.


In short, our standard only makes sense if

o    the startup already has credible investors (with a relatively sizeable stake) on board with proper governance rights, etc…

o    the founders have a clear and fair understanding of the company’s valuation

      - Potential use of an „early-bird-bonus”: Signing within 2 weeks:  3% on pre-money valuation, for the next week: 2%, and the next week 1%.

o    you would like to raise capital relatively quickly (I.e. Postpone the administration into the future)


The terms for such a convertible should be defined as follows

o    No floor

o    Interest rate 0%

o    Fixed pre-money Valuation of current round (=Cap)

      - If next round is at a lower valuation investors profit from the lower valuation

      - As valuation is fixed no discount and no interest (or extremely low)

      - Keep in mind that in our case valuation is not the main driver for using a convertible but time savings.

o    Fixed maximum amount of convertibles issued (As with any standard equity round)

o    Fixed conversion:

      - either at the next round

      - at any potential exit event in between – or repayment incl. Exit Premium of x%, which corresponds to a liquidation preference of 1+x% for the lender

      - at maturity (maximum 9-12 months, better 6 months) or prolongation if both parties agree

§  This also has the advantage that the convertible (as per Austrian tax law) is considered equity and not debt.

o    Calculation of % for exit and maturity

o    Calculation of % in case of a financing round (Equity or new convertible)

Like any other shareholder the lender will obviously dilute during a further financing round but may be given the option to participate in the round to the same conditions as the new investor (Synthetic "Subscription rights")

 Tips for startups: When negotiating with new investors don’t promise fixed % but a fixed pre-money Valuation.

o    At the time of conversion, the respective share capital must be paid on top of the capital invested.

o    Every lender below a certain threshold (Less than 200k investment amount) will be syndicated (via primeCROWD Trust) →  Only 1 entity on the captable.

o    Convertible lenders will be given merchantable information rights

o    Lenders will need to agree to an accession to any existing shareholder agreements, which will have to include the standard participation terms like liquidation preference, Tag-along, Drag-along, Guarantees, Vesting, etc..)