Many risks are entailed in the process of raising capital in the initial stages of a technological venture. As a result, the negotiations between the parties can take a long time, during which entrepreneurs find it difficult to effectively promote the affairs of the project and the company, as they are completely invested in raising capital. On the other hand, investors also find themselves investing significant time and resources in a project that its future is veiled with uncertainty.
Investing through a convertible loan is a process which its main aim is to simplify the process of raising capital, both for the developers and for the investor, and to assure that most of the parameters of the current investment will be determined as a function of the future fund raising performed by the company.
Thus, if the venture is not successful, and the company is unable to raise additional capital, the investor’s current status is of a lender (not of a shareholder) that is preferred over the entrepreneurs, who are deemed as shareholders in the event of liquidation and receivership of the Company.
In this review, we will discuss the key principles of investing through a convertible loan, the logic behind the mechanism, and the main advantages that guide the parties in formulating the transaction and its characteristics.
Pre Seed- Raising Capital in the Project’s Initial Stages
The process of raising capital is a complex process full of ups and downs, disappointments along with successes. The difficulty grows even more when it comes to raising initial capital, for several reasons: First, the intrinsic circumstances are that the project is in a stage of many high risks, and few are the investors who will agree to invest in such a stage. Second, without the initial capital, the venture will not rise, and the dependence of the entrepreneurs in the current capital raising is total. Third and last, the ability of entrepreneurs to try and raise funds and simultaneously develop the venture itself is almost impossible; fundraising is a task that requires significant management evaluations, and during this period the project itself is usually set aside and its development is very limited.
Those are exactly some of the major reasons to raise capital via a convertible loan. The convertible loan mechanism assists entrepreneurs to raise capital in a relatively simple channel, which is more effective and efficient, as it requires lesser resources than raising funds through the purchase of shares.
What is it all about: A convertible loan is a loan which the investor provides to the company in one or more payments, and in return he/she will be entitled to convert their loan into company shares upon the future occurrence of events agreed on in advance. The loan enables the investor on the one hand and the developers on the other hand not to spoil their time and resources negotiating about the fund-raising terms, since these conditions would be a function of the future capital raising performed by the company.
In other words, within the current round of capital raising, the status of the current investor is of a lender (and not of a shareholder), and his/her loan will be converted into shares, with and subject to the future capital raising performed by the company, which will determine most of the business conditions and the rights which will be linked to the shares the lender will receive.
Discussion of the Main Mechanisms in Raising a Convertible Loan
Within the negotiations for investing in the company, one of the key parameters for raising capital is the price per share . As part of a convertible loan, this issue is spared from the parties, since the share value is derived from the future share price that will be determined during future capital raising in the company. In most cases, the current investor will receive a discount in the share price (Discounted share price) compared to investors who will join in the future capital raising, and in a way which will reflect the increased risk that he/she assumes, compared to future investors. In this context, it may be noted that the discount can also be given as a function of the length of time during which the company manages to raise more capital via share raising.
In addition, a central question that must be addressed is what is the best time to convert the loan into shares. We shall remind you that the current status of the investor is of a lender, which is why it is important to discuss and agree about the duration of the loan, and when and under which conditions the investor will be entitled for immediate repayment on it, if any. In most cases, the lender’s right to demand repayment is contingent on the passage of a long duration, in order to give the company and its entrepreneurs a prolonged, convenient option for raising share capital. Simultaneously with the completion of the fund raising mentioned, the loan will be automatically converted into shares (Automatic Conversion). Thus, only if the company is unable to raise share capital after a long time, then the lender (the first investor) will be entitled to reclaim his/her loan back from the company, and to demand the conversion of his/her loan into shares (Optional Conversion), an action that will probably not be relevant in these circumstances, and alternatively, may act to liquidate the company’s assets to try and get back the loan he had gave the company, if any such assets exist.
Finally, the question arises as to what are the additional rights the lender will be entitled to upon future stock allocation. We shall mention again that in most cases, an investor who receives shares of the company is a sophisticated investor, which demands and receives excessive rights attached to the shares, such as the right of first refusal, pre-emptive rights, the right to appoint directors, restricted previsions, bring along rights and obligations, anti-dilution etc. It is important to note that the negotiations between an investor who receives company shares and the company, can last for a long time, inter alia due to tiresome discussions about these rights, if they will be granted to the investor, and how. Similarly, the lender also expects that in the future, the shares that are to be allotted to him/her will mirror certain rights in the company, even if in most cases the status of the shares investor is more significant in the company, inter alia, due to the fact his/her total investment sum in the company is significantly higher than that provided to the company as a convertible loan.
Raising capital through a convertible loan is an efficient process that includes significant benefits for both the entrepreneurs and the company seeking to raise capital, as well as for the sophisticated investor. Knowing the common mechanisms that are applicable to a convertible loan, along with knowing the dynamics that develops in the future between the company and its investors in the future investment round, will enable forming a convertible loan that will know how to serve each party’s important interests, and at the same time will allow the company to join additional investors in the future in a manner that will integrate with the current capital raising.