When cash is tight or a valuation is not yet reliable, many startups reach for a convertible loan. It is fast, cheaper than a full equity round and pushes the valuation question back. But it comes with risks of its own that should be clear before signing. This article explains how it works, the key terms and when each option fits. It does not replace legal or tax advice.
Key takeaways
- A convertible loan is initially a loan that is later converted into shares, usually in the next funding round.
- Discount, valuation cap, interest and term determine how large a stake the lenders end up with.
- The advantage is speed; the drawback is open dilution and the risk that the loan falls due before the round happens.
How a convertible loan works
The investor lends money to the company. Instead of being repaid, the loan is converted into shares at an agreed event, usually in the next funding round. The valuation is not set today but when a new investor sets a price. In a German GmbH the conversion itself requires a capital increase that must be notarised.
The key terms
Discount
The reduction on the price of the next round. It rewards the early investor for taking the risk earlier. Discounts in the low double-digit percentage range are common.
Valuation cap
The upper limit of the valuation at which conversion takes place. If the valuation rises sharply in the next round, the cap protects the investor from entering at a much higher price.
Interest and term
The loan usually bears interest, and the interest is often converted as well. The term sets by when conversion or repayment must happen. If it expires before a round has taken place, repayment is on the table, which the company often cannot afford.
Conversion trigger
The contract defines from which round the conversion applies, for example from a minimum round size. The case of a sale of the company before the next round should also be regulated.
Convertible loan and equity sale compared
- Speed and cost: A convertible loan is quicker and cheaper to implement because no valuation has to be negotiated and no capital increase notarised.
- Valuation: Open with a convertible loan, fixed immediately with an equity sale.
- Dilution: With a convertible loan only visible later and dependent on discount, cap and interest. With an equity sale, immediately calculable.
- Risk: The loan remains a liability until conversion. That can weigh on the balance sheet and complicate negotiating the next round.
When a convertible loan makes sense
A convertible loan fits when a round is foreseeable but still months away, when existing investors are meant to bridge the time, or when the valuation is still too uncertain to negotiate fairly. Go for a full equity round if you want to win a new lead investor who sets valuation and terms bindingly, or if a clear capital base is needed for the next few years. How a dilution scenario looks can be tested with the equity dilution calculator.
A convertible loan postpones the valuation but does not solve the funding question. The next round still has to succeed.
What to settle before signing
- What dilution results in three scenarios for the next valuation (low, expected, high)?
- What happens if the term expires before a round takes place?
- How does the loan appear on the balance sheet, and is a subordination agreed?
- Are all convertible loans reflected in the cap table and the financial model? See also finance setup after a funding round.
Common questions
What is a convertible loan?
A loan that is not repaid but converted into company shares at an agreed event, usually the next funding round. The valuation is only set then.
What do discount and cap mean?
The discount is a price reduction for the early investor compared with the new investors of the next round. The cap is an upper limit on the valuation at which conversion takes place. Both determine how many shares the investor ends up with.
What happens if the conversion does not take place?
Then the loan remains a liability. At the end of the term the investor can demand repayment unless agreed otherwise. That is why term and extension options should be clearly regulated in the contract.
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