How to better negotiate convertible loans—an entrepreneur’s perspective

21.07.2021 07:00, Isabelle Mitchell

An entrepreneur, an investor, and a lawyer participate in an interview series… What sounds like the setup for a joke is serious business: In a new series, we present three different perspectives on convertible loans, term sheets, and shareholders’ agreements so that you can gain new insights to negotiate with more confidence. We start the series with the entrepreneur’s perspective on convertible loans: PXL Vision founders Michael Born and Karim Nemr share their experiences with this financing method.

In the first part of a new series, we look at convertible loans. Convertible loans are a financing method that is becoming increasingly popular in Switzerland: Startups receive a loan that will be converted into equity (common stock or equity shares) at the next qualified financing round. Investors who provide convertible loans can receive interest payments and a discount on the stock price they pay compared to the price incoming investors have to pay in the financing round. Convertible loans often come with a cap—a maximum valuation at which the loan can be turned into equity. 

This financing method has the advantage that the loans can usually be executed quickly and without too much administrative effort. The startup may postpone the valuation discussion until it has reached additional milestones with the help of the loan.

To learn more about an entrepreneur’s perspective on convertible loans, we asked not one but two experts: Michael Born and Karim Nemr, two PXL Vision founders, share their thoughts on this specific financing method for startups. Michael and Karim are both serial entrepreneurs: The two founded software company Dacuda, which Magic Leap acquired in 2017. After the successful exit, Michael, Karim, and fellow Dacuda team members founded PXL Vision, a Venture Leaders Mobile 2021 that provides fully automated digital identity verification.
 

Was it easy to find an investor who was willing to give you a convertible loan?
Michael: Getting funding is never easy, but as we had a convincing product-market fit, the effort to attract first investors who were willing to grant a convertible loan was reasonable.

In which situation is a convertible loan the most appropriate financing instrument?
Michael: When you need to get cash fast—which also ensures certain stability for the organization in a critical stage—a convertible loan is often the way to go. It enables you to get money from a first investor in a short period so that you can continue building your business while organizing the rest of the financing round. It often makes sense to postpone detailed and sometimes lengthy discussions about financing terms to fully concentrate on achieving the next critical milestones. This is especially the case if an investor is willing to adhere to the terms of a future lead investor.

What are conditions that entrepreneurs should not agree to in relation to convertible loans (e.g., interest rates, conversion)?
Karim: Don’t accept interest rates; you are not looking for an actual loan with payback but a long-term investment. A good investor understands the risk of investing in a startup and will want you to make the best use of the money provided and, thus, will not insist on having interest rates. 
Try to avoid caps in convertible loans. While it is understandable that investors want upside protection on the valuation, having a cap in the CLA [convertible loan agreement] can be seen as having a baseline valuation for the next financing round, and it can make negotiations much harder.
Accept terms where you are obliged to repay the loan only in case you are in breach of contract, in case of change of control of your company, or on the maturity date. There is no other reason the lender should be able to ask for a repayment.
If possible, try to negotiate a conversion of the loan on the maturity date, even in the non-event of a financing round. This is hard to get through but not impossible. Usually, the lender would want at least the option to convert on maturity, which makes sense.
Don’t accept too small amounts for a qualified financing event. You don’t want a conversion trigger for a super small financing round or when a stock option is exercised by one of your employees.
Don’t accept liquidation preferences for a convertible loan. You will most probably not get around it in your next financing rounds, but there is no place for it in a loan agreement. Again you are looking for longer-term investors who want to help you get to the next financing round in the coming six to 12 months.
 
What are some disadvantages of convertible loans founders must be aware of?
Michael: There are often a few challenges and pitfalls to consider. Suppose you or the investor wants to get clarity regarding most investment terms already before signing the convertible loan agreement. In that case, you may end up negotiating about more parameters (often including shareholder’s agreement terms) than you initially considered. This would make the process slower than you had hoped. 
If it is obvious that the lead investor of the first round will be the same as the convertible loan investor, it may make more sense to directly work out the investment agreement. Also, the legal language is extremely important: If the conversion terms are not crystal clear, it may lead to very difficult discussions at a later point, which is far from desirable, as a good relationship with your investors is key for your business. 
Last but not least, you may be forced to define conversion terms for the event that there is no financing round within a specific time frame. This might defeat the purpose, especially if the reason for choosing a convertible loan was to avoid valuation discussions and not to send any valuation signals to future investors. 
So in sum, you should carefully consider if, in a given situation, an investment agreement or a convertible loan agreement is the more appropriate way of financing. 

Karim: Depending on the investor, you may still have some tough negotiations—around valuation cap, conversion price, conversion mechanism, etc.—which takes time and distracts from your business. 
The valuation cap, as well as the defined discount, may have an impact on the negotiations in your next financing round. If your discount was too high, future investors might not want to pay a much higher price.
In Switzerland, convertible loans are not as common as they have been in the US. So, some investors may need some convincing first to go for a convertible loan, or some may even have a policy against it.

A key element of a term sheet is the presence of a discount rate. What do you think is a fair discount rate at conversion?
Michael: It heavily depends on the situation, the status of a company, and the conversion timeline and terms, but generally, a discount rate between 10% and 15% may be reasonable.

What happens if there is no financing round after a convertible loan?
Karim: Typically, the loan expires at the maturity date and needs to be paid back if there was no qualifying financing event. Commonly, the investor has the option to convert the loan anyway. If there is a cap, usually, the conversion price will be calculated by dividing the maximum valuation by the number of shares (excluding the shares to be issued as part of the convertible). If you don’t have a cap, you could potentially agree to a defined share price, but this can also be counterproductive in the next financing round, as it provides a baseline for negotiation. So, it is really important to find good investors who understand the mechanics of a convertible loan and the risk of investing in a startup. If you are generally on a good track but need more time to get your financing round together, usually, you would agree with your investors to extend the maturity date. Any investor asking for repayment would probably not be an investor you want to have on your cap table anyway.


To learn more about different financing options and get the possibility to pitch in front of investors, sign up for the Innosuisse Start-up Training.