Convertible loans: a loan with interest (whether actually paid or accrued), in which the loan will convert to equity shares at a designated time or event, for instance, an investment round. The conversion rate will be predetermined with a discount, fluctuating between 10-30%, and can have a maximum valuation, named ‘cap’.
Convertible loans are a popular path to raising capital for startups; this is a trend that merits some scrutinisation.
There are a few obvious short term benefits of the loans: they are less expensive than equity transactions, (usually) have no control rights, and the valuation discussion is postponed. However, under the shiny exterior of these benefits are three major drawbacks that reveal themselves further down the road.
These drawbacks are significant enough that I will usually avoid using this instrument.
1) There is a valuation, after all
Although a valuation is not formally agreed upon in a convertible loan, there is still a valuation in practice. The valuation is hidden within the cap. The cap is a pseudo valuation with a strong psychological effect. The cap functions as a yardstick to all future valuation discussions. But what if there is no cap? From an investment point of view, not having a cap is illogical (read: stupid). If the company is wildly successful the conversion without the cap will mean bad news for the convertible loan holder. Generally speaking a cap will always be in place, and thus; there is a valuation.
2) Misalignment of investor and founder
A convertible loan introduces undesirable contradictory incentives to the company, between the investor and the entrepreneur. The investor wants to have a low conversion because this will provide him with the most equity. On the other hand, the entrepreneur wants the highest possible conversion for less dilution. I find these opposite stances problematic, and would like to be in the same boat as the entrepreneur – both of us going in the same direction. When it comes to the value of the company, the entrepreneur and investor should always be aligned.
3) Lack of cap table clarity
A convertible loan brings with it insecurity and obfuscation of the cap table. Who owns what percentage of the company? At any given moment in time it is not clear what the property rights are in the company. I see this a lot, especially when convertible loans are stacked, meaning multiple convertible loans with different interest rates, discounts and caps. This is a red flag, and usually the end of the investment process for me. Unfortunately I see more and more of these chaotic cap tables. I blame the ease of closing a convertible loan without thinking about the consequences for the next round of financing. Shortsighted fundraising strategies can create major cap table issues later on.
Are convertible loans never a good option? Oh yes, a convertible loan is a good instrument for short term (!) bridging with current shareholders. For equity investments I believe the disadvantages of convertible loans outweigh the advantages. Concluding, long term financing in equity with associated control rights is much better for both parties.
Guest article by Frank Appeldoorn, Managing Partner at Arches Capital
Frank Appeldoorn (Managing Partner at Arches Capital) has earned his credits as a venture capitalist with an operational finance and IT background, developing and driving financial performance of strategic business plans. He started the Volta Ventures organisation in the Netherlands, including deal sourcing, closing and deal follow-on. Prior to Volta, Frank acted as an advisor to IT startups in their fundraising efforts. Frank holds a master’s degree from Rotterdam School of Management and ESADE in Barcelona, Spain. He also received a Register Controller Degree from Nyenrode University. Frank has lived and worked in The Netherlands, Germany, Spain, and the US. Frank is married and has three kids. When all this leaves him some spare time, Frank loves to play tennis and keep in shape as road cyclist.