Eliran Ben-David MBA2020 describes one of the most common fundraising instruments for startups, and its advantages and disadvantages, to help entrepreneurs make an informed decision.
As a corporate lawyer in Israel, I advised venture capital funds and early-stage ventures on establishing their business, commercial affairs and negotiations, and of course, M&A transactions and financing rounds. One of the things I observed from time to time, is that when it comes to fundraising, especially in the first rounds, young entrepreneurs are not always aware of the various instruments they can turn to, and especially what would be the suitable one for them.
Usually, when a startup company seeks fundraising, it goes into one of two directions: equity investment, under which the company issues shares of the company to an investor in exchange for cash, or a loan, under which the company creates a debt towards a lender.
But there is another method, convertible security, which is a combination between equity investment and the “regular” loan.
So, what is a Convertible Loan?
A convertible loan is a short-term debt, and that is an important thing to keep in mind, and like most loans, it has a maturity date, an interest rate, and a list of events that upon the occurrence of which, the loan should be repaid. Despite its similarities, convertible loans have a small twist that distinguishes them from regular loans; a right (but not an obligation) to convert the loan into an equity stake in the company at some pre-defined point in the future. In fact, a convertible loan is a hybrid tool that transforms a lender to a shareholder upon the loan conversion.
How does it work?
Although there are few different types of convertible securities such as convertible loan agreement (“CLA”), convertible note, or a simple agreement for future equity (“SAFE”), they all have the same basic idea – upon the next equity investment round in the company, the amount provided to the company under the convertible security is converted into shares of the company. Those shares will have the same rights and preferences as the shares that were issued to the equity investor. Given that the lender who provided the loan under the convertible security took a higher risk than the new equity investor (since it invested at an earlier stage), the shares that issued to such lender upon conversion will be at a discount on the price per share to that agreed with the new equity investor(s).
Pros and Cons of fundraising via convertible securities
One of the major advantages of convertible security is that it eliminates the need to deal with one of the most critical questions – valuation. Because a convertible security investor doesn’t really buy shares at that moment, there is no need to determine the price per share and the company’s valuation – a sensitive issue, since often the parties simply disagree; not least because at an earlier stage there are few external parameters like revenue or comparables that can assist.
Another advantage is that it’s a quicker process to execute – an extremely important parameter in the early days of the venture. The agreements being used for such instruments are substantially shorter than those of an equity investment. Hence, the legal costs are much lower, they take less effort to negotiate and are far quicker to conclude. This allows the company to allocate almost all of the capital to develop its business, rather than seeing it eaten away by higher transaction (e.g. legal, time) costs.
However, it’s not all rosy. The convertible security has potential downsides. Although compared to equity investment there is no need to deal with the rights that will be granted to the lender (such as for example the right to appoint a director, veto rights, liquidation preference, etc.) the flipside is that lenders can seek repayment of the loan in certain scenarios and if – for some reason – the loan is not converted into shares. Not something that a young company with limited resources necessarily wants to face.
Moreover, the status of a lender grants priority over shareholders such as the founders or other equity investors, if the company becomes insolvent.
In addition, in recent years, convertible instruments have raised tax exposure issues due to the discount and the interest elements.
So, what is better for your company – Share Purchase Agreement or a Convertible Loan Agreement?
In general, there is no one single definite answer to that question, and like many situations during a startup’s life cycle, it depends.
A convertible security is an efficient tool to raise funds at an early stage of the company, or as an interim solution before a substantial equity investment. Convertible security enables the company to raise funds without causing an immediate dilution of the current shareholders and without much involvement of the lender in the company’s day-to-day business and decision making.
In the end, it seems that the context of the specific need for funds will ultimately determine the type of instrument one will turn to and bear in mind that sometimes, the investor or lender will be the one leading the direction.