Many risks are entailed in the process of raising capital in the initial stages of a technological\u00a0venture.\u00a0As a\u00a0result,\u00a0the negotiations between the\u00a0parties can take a long\u00a0time,\u00a0during which entrepreneurs find it difficult to effectively promote the affairs of the project and the\u00a0company,\u00a0as they are completely invested in raising capital.\u00a0On the other\u00a0hand,\u00a0investors also find themselves investing significant time and\u00a0resources in a project that its future\u00a0is veiled with uncertainty.<\/p>\n
Investing through a convertible\u00a0loan\u00a0is a process which its main aim is to simplify the process of raising\u00a0capital,\u00a0both for the developers and for the\u00a0investor,\u00a0and to assure that most of the parameters of the current investment\u00a0will\u00a0be determined as a function of the future fund raising performed by the company.<\/p>\n
Thus,\u00a0if the venture is not\u00a0successful,\u00a0and the company is unable to raise additional\u00a0capital,\u00a0the investor’s current status is\u00a0of a lender (not of\u00a0a\u00a0shareholder)\u00a0that is preferred over the entrepreneurs, who are deemed as shareholders\u00a0in the event of liquidation and receivership of the Company.<\/p>\n
In this review, we will discuss the key principles of investing through a convertible\u00a0loan,\u00a0the logic behind the\u00a0mechanism,\u00a0and the main advantages that guide the parties in formulating the transaction and its\u00a0characteristics.<\/p>\n
Pre Seed- Raising Capital in the Project’s Initial Stages<\/u><\/strong><\/p>\n The process of raising\u00a0capital\u00a0is a complex process full of ups and\u00a0downs,\u00a0disappointments along with successes. The difficulty grows even more when it comes to raising initial capital,\u00a0 for several\u00a0reasons:\u00a0First,\u00a0the intrinsic circumstances are that the project is in a stage of many high risks,\u00a0and few are the investors who will agree to invest in such a stage. Second,\u00a0without the initial\u00a0capital,\u00a0the venture will not\u00a0rise,\u00a0and the dependence of the entrepreneurs in\u00a0the current\u00a0capital\u00a0raising\u00a0is\u00a0total.\u00a0Third and\u00a0last,\u00a0the ability of entrepreneurs to try and raise\u00a0funds\u00a0and simultaneously develop the venture itself is almost\u00a0impossible;\u00a0fundraising 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.<\/p>\n 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.<\/p>\n What is it all about:\u00a0A convertible loan is a loan which\u00a0the investor provides to the company in\u00a0one or more payments,\u00a0and in return he\/she will be entitled\u00a0to convert their loan into company shares\u00a0upon the future occurrence of events agreed on in advance.\u00a0The loan enables the investor on the one hand and the developers on the other hand not to spoil their time and resources negotiating\u00a0about the fund-raising terms, since these conditions would be a function of the future capital raising performed by the company.<\/p>\n In other\u00a0words,\u00a0within the current\u00a0round of capital raising,\u00a0the status of the current investor is of a lender\u00a0(and\u00a0not of a\u00a0shareholder),\u00a0and his\/her loan will be converted into shares, with and subject to the future capital raising performed by the company,\u00a0which will determine most of the business conditions and the rights which will be linked to the shares the lender will receive.<\/p>\n Discussion of the Main Mechanisms in Raising a Convertible Loan<\/u><\/strong><\/p>\n Within the negotiations\u00a0for\u00a0investing in the\u00a0company,\u00a0one of the key parameters for raising capital is the price per share\u00a0.\u00a0As part of\u00a0a convertible\u00a0loan,\u00a0this 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\u00a0the company.\u00a0In\u00a0most\u00a0cases,\u00a0the current investor will receive a discount in the share price\u00a0(Discounted share price) compared to investors who will join in the future\u00a0capital raising,\u00a0and in a way which will reflect the increased risk that he\/she assumes, compared to future\u00a0investors.\u00a0In 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.<\/p>\n In\u00a0addition,\u00a0a central question that must be addressed is what is the best time to convert the loan into\u00a0shares.\u00a0We shall remind you\u00a0that 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,\u00a0if\u00a0any.\u00a0In most\u00a0cases,\u00a0the lender’s right to demand repayment is contingent on the passage of a long\u00a0duration,\u00a0in order to give the company and its entrepreneurs a prolonged, convenient option for raising share capital. Simultaneously with the completion of the fund raising\u00a0mentioned,\u00a0the loan will be automatically converted into shares\u00a0(Automatic Conversion).\u00a0Thus,\u00a0only if the company is unable to raise share capital after a long time, then the lender\u00a0(the first investor)\u00a0will be entitled to reclaim his\/her loan back from the company,\u00a0and to demand the conversion of his\/her loan into shares\u00a0(Optional Conversion), an action that will\u00a0probably not be relevant in these\u00a0circumstances,\u00a0and alternatively, may\u00a0act\u00a0to\u00a0liquidate the company’s assets to\u00a0try and get back the loan he had gave the company,\u00a0if any such\u00a0assets exist.<\/p>\n Finally,\u00a0the\u00a0question arises as to\u00a0what\u00a0are the additional rights the lender will be entitled to upon future stock\u00a0allocation.\u00a0 We shall mention again that in most\u00a0cases,\u00a0an investor who receives shares of the company\u00a0 is a sophisticated\u00a0investor,\u00a0which demands and receives excessive rights attached to the\u00a0shares,\u00a0such\u00a0as the right of first\u00a0refusal,\u00a0pre-emptive rights,\u00a0the right to appoint\u00a0directors,\u00a0restricted previsions, bring along rights and obligations, anti-dilution etc.\u00a0It is important to note that the negotiations between an investor who receives company shares and the company, can last for a long\u00a0time,\u00a0inter alia due to tiresome discussions about these\u00a0rights,\u00a0if they will be granted to the\u00a0investor,\u00a0and\u00a0how.\u00a0Similarly,\u00a0the lender also expects that in the\u00a0future,\u00a0the shares that are to be allotted to him\/her will mirror certain rights in the\u00a0company,\u00a0even if\u00a0in most cases the status of the shares investor is more significant in\u00a0the company,\u00a0inter 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.<\/p>\n