Convertible loans - who uses them and why are they risky?

Convertible loans are a way for startups and early-stage businesses to raise capital without immediately diluting ownership, which sounds an attractive option. Convertible loans create significant risks that can lead to serious consequences for the borrower.

How it works

A convertible loan is a form of debt financing that can be converted into equity (shares) in the borrower’s company at a later date. These loans typically offer the lender a discount on the price of shares in a future funding round or set a valuation cap, ensuring the lender can convert the loan into equity at an attractive price.

Major risk for borrower

Convertible loans often come with onerous terms and can result in future dilution of ownership and loss of control over the company. This is because the lender will often receive shares in the company at a discount to the next funding round price, or based on a valuation cap. If the company’s valuation increases significantly, this can lead to substantial dilution for the founder and existing shareholders. Over time, this can result in the borrower losing a controlling interest in the business, especially if the company raises multiple rounds of funding or if the loan is converted into a large equity stake.

The lender may even demand board representation or influence over strategic decisions, such as the direction of the company, acquisitions, or exits. This shift in control can be particularly problematic for founders who want to maintain control of their business’s future direction.

Other risks

Convertible loans often come with various default clauses that allow the lender to enforce the loan or accelerate its repayment, which means that the full loan balance (principal and interest) becomes due immediately. Common default clauses include :-

• Payment Default - the lender can demand full repayment of the loan (plus any accrued interest), which can place significant financial strain on the company. If the borrower cannot repay the loan, this could lead to costly debt collection actions or legal proceedings and could force the company into insolvency.

• Non-Conversion Default - if the loan is not converted into equity within the expected timeframe or if no conversion event occurs (e.g., a new funding round), this may trigger a default. The lender may then demand immediate repayment of the loan amount in cash, which could be difficult for the borrower, particularly if the company hasn’t yet raised sufficient capital.

• Breach of Covenant or Warranty - such as failure to meet agreed financial targets, failure to disclose material changes, such as new debts, changes in management, or loss of key customers and/or inability to maintain required financial ratios (e.g., debt-to-equity ratio).

• Change of Control - a change of control clause allows the lender to declare a default if there is a significant change in the ownership or control of the company. This might occur if the company is sold, merged, or undergoes significant restructuring.

• Material Adverse Change (MAC) - clause which allows the lender to declare the loan in default if there is a significant, negative shift in the company's financial health or business prospects.

How can borrowers protect themselves?

Key elements borrowers should seek to negotiate in a convertible loan agreement to minimie risks and avoid onerous conditions:

• Conversion Terms - negotiate for a higher valuation cap to ensure that the loan is converted into equity at a more favourable price, especially if the company's valuation increases significantly before the next funding round and/or seek a lower discount rate on the conversion price. Ensure the terms for triggering conversion are clearly defined. For example, consider negotiating flexibility in the events that trigger conversion, such as qualifying financing rounds or a strategic sale of the company.

• Interest Rates - try to negotiate for a lower interest rate. Convertible loans often have interest rates ranging from 5% to 10%. A lower interest rate means less financial burden on the business, especially if the loan is not converted into equity for a longer period.

• Loan Repayment Terms - seek flexible repayment options, such as the ability to extend the loan or negotiate a lower repayment schedule in the event of financial difficulties.

• Clear Definitions of Default - carefully define what constitutes a default and ensure that minor breaches do not trigger an automatic default. Negotiating more flexibility on covenants and warranties can prevent premature defaults from triggering repayment demands.

• Avoidance of Acceleration - try to negotiate for limited acceleration clauses. For example, if the loan defaults, ask for a gradual repayment plan rather than immediate full repayment. This provides more time for the borrower to arrange funds.

• Enforcement Restrictions - ensure that the lender cannot take drastic enforcement actions, such as forcing liquidation or taking control of the company, unless there is a genuine and significant breach.

• Limit Conversion to a Minority Stake - seek a cap on the percentage of equity the lender can hold after conversion to ensure the lender doesn’t gain control of the company.

• Early Repayment Options - negotiate the ability to repay the loan early without heavy penalties. This gives the company more flexibility if it achieves better financial stability or secures alternative financing options.

• Cap on Dilution - ensure that the amount of equity issued upon conversion does not result in excessive dilution for existing shareholders, particularly the founders and early investors.