For startups just getting going nicely, a convertible loan can be a very welcome cash injection. NOM is one of the investment parties that have it in their offerings. Such a convertible is actually in between a loan and equity.
You have a good idea, decide to start a business, and now need capital to initiate growth. So what do you do? You take out a loan, or issue shares to an investor. Often enough, both fail. The young startup has too little cash flow to qualify for a loan, valuing shares is virtually impossible at that early stage.
That's a situation where a third option comes around the corner: the convertible loan. This is similar to a regular loan, including agreed-upon interest rates and repayment rules. Difference is that those payment obligations are usually suspended temporarily, to give the startup a chance to work on structural cash flow.
And the main difference from a regular loan: with such a convertible, there is an agreement that the lender can convert the loan to equity at a certain point in time. That certain moment can be a new round of investment, an exit, another milestone, or simply a pre-arranged date.
For the founder, such a convertible loan can be a great idea. Money to build the startup is available, while paying interest and paying off debt immediately are not yet necessary. That leaves room for entrepreneurship. Still, as a (starting) entrepreneur, you need to think carefully about the consequences in the slightly longer term. After all, the provider of the loan is taking on extra risk and wants to see compensation for it.
That is mainly in converting the loan amount into a share of the startup's shares. At the time of conversion, the value of the company is determined and the investor receives a share in the amount of the loan provided. In short, the higher the company value, the smaller the share.
Please note the conditions
For the founder, it is important to pay very close attention to the agreed-upon ground rules when establishing such a convertible loan. The term of the loan determines how quickly the startup must have a solid cash flow. After all, the shorter the term, the shorter the exemption from interest and repayment. Therefore, that grace period is also something to keep a sharp eye on. By that time, the cash flow must take into account repayment and interest payments unless a conversion is made.
Lenders of convertible loans regularly demand a discount on the share price applicable at the time of conversion. This should be seen as risk compensation. Another thing to keep an eye on is whether there is so-called rolled-up interest. In that case, although the founder gets deferred interest payments, that deferred interest comes as extra on top of the amount to be redeemed. Because of the accumulation of interest, that portion gets bigger and bigger. So pay attention.
NOM is not a fan of it, but other investors (such as angel investors in the US) love it: a valuation cap. In that case, the maximum value of the company is determined in advance. If the startup's value grows faster than expected, the loan amount is consequently converted into a much larger stake than without such a cap. The investor thereby guarantees a minimum equity stake. Again, watch out.
An example: you have raised a 250,000 convertible loan with your startup. After a while it is time to convert, at a time when the value of your startup is set at 2 million euros. There are one hundred thousand shares outstanding with a price of 20 euros per share. Suppose a valuation cap of 1 million euros has been negotiated by the investor. This means that the lender pays 10 euros for one share. The loan converts at this price, 25,000 new shares are issued. This gives the lender a 20% stake (25,000 / 125,000).
And the NOM? That provides subordinated loans, invests in exchange for shares, and also leaves convertible loans. With that we take risk by supporting startups in the early phase. The valuation discussion is pushed further ahead. The investment process is therefore a lot smoother than with equity participation, good for NOM and startup. NOM does always ask for a discount on the share price.
In short, a convertible loan can be a great idea for a founder who is looking for growth money and is confident that cash flow will come on quickly. The same is essentially true for an investor. Who gives the startup a little more room to fulfill its promise and then secures a stake in the fledgling company, not to mention the return on the loan's interest.