As a young innovative company, you are undoubtedly looking for capital to achieve your growth ambition. Not an easy search, that's for sure. Simply because in the early phase you often have little cash flow and there are still too many uncertainties. And yes, that makes it quite difficult to take out a loan or issue shares. But there is another option: the convertible loan. Let me explain why this funding option can also be interesting for your company.
Basically, a convertible loan is an ordinary loan. Like any other loan, you enter into an agreement with a lender. The difference is that the agreement also stipulates that the lender can convert the loan into shares in your company at a later date. And just like any other loan, there are clear agreements about interest and repayment. Only: with a convertible loan, repayment obligations and interest payments are usually temporarily suspended.
The benefits for early-stage startups in particular are easy to guess. Because you don't immediately pay interest and pay off debt, you create more financial peace of mind to work on your business. Indeed, often even the means to repay are lacking and you really need the available capital to grow and structurally generate cash flow.
Another advantage is that you do not (yet) have to argue endlessly with the investor about his rights or the potential value of your company. So you retain full control and, moreover, it is virtually impossible to make a realistic value calculation at the early stage. There is simply too little data available for that.
Together you determine the conversion moment
By providing the loan, the investor shows his confidence in the potential of your company. He therefore has the express intention of becoming a shareholder at a later date. That so-called conversion moment, jointly determined in advance, can be the entry of one or more new investors, an exit or other milestone, or simply an agreed upon fixed date.
Because the investor joins at an early stage, he is taking a considerable risk. After all, a convertible loan is often granted when much is still unclear about the valuation of the company. For that risk taken, the investor logically wants to be compensated. In the form of a higher interest rate, for example. But the compensation can also take the form of a discount, or a rebate, on the price per share applicable at the time of conversion.
Still, a few points of interest
In short, a convertible loan is an interesting way for young innovative companies to raise capital. And relatively easy to arrange, too. After all, the loan can be secured without too much red tape. Moreover, the transaction costs are considerably lower than if you want to draw up a shareholder agreement, for example. Still, there are a number of things to take into account, besides the risk compensation.
Thus, when negotiating the loan, you should pay close attention to the term. As with a normal loan, this is the period of time during which you must repay the sum borrowed. But because a convertible loan is usually not repaid in the beginning, the term is relatively short.
Suppose the total term is five years and the grace period is two years. That means that if the loan does not convert after two years, it must be repaid in three years. That can put considerable pressure on your cash flow. Therefore, it is important to try to estimate early on whether your cash flow after the grace period ends will be sufficient for interest payments and repayments.
Another concern has to do with the deferral of interest payments. Of course, that deferral is a pleasant aspect of a convertible loan. It just becomes a lot less attractive when there is so-called rolled-up interest. The deferred interest is then added to the principal of the loan. The stacking, the rolling up, of the interest makes the principal larger and larger, and with it the amount that can eventually be converted into equity. If you leave the loan standing for several years and interest on interest is charged, it can have a serious impact.
And then there's the valuation cap. Unlike mainly American investors, NOM is not exactly a fan of this. A valuation cap means that the investor determines in advance what the maximum valuation of your company will be against which may be converted. So if your company grows faster than expected, the loan will be converted into a much larger stake than without such a cap. In other words, with a valuation cap, the investor guarantees a minimum equity stake. Indeed, another point to note.
What does NOM itself do?
A convertible loan, as mentioned, can be a welcome funding option for both the entrepreneur and the investor. As an investment manager, I am also enamored with the loan. As does NOM itself, for that matter. After all, we are there to support companies in their growth and development plans. That's why we also offer promising startups in the risky early phase opportunities for funding, including taking out a convertible loan. However, we always ask for a discount on the share price. Is a convertible loan exactly what your company needs right now? Feel free to call us for questions or more information.