Understanding Convertible Loans
> Many people have recently inquired about the concept of convertible loans. In fact, my own venture is right now in the process of closing a second-stage "B" round funding package that's comprised of both additional common stock (equity) as well as a convertible line of credit.
The two main questions in this area are: 1) How do these convertible loans actually work, and what are their features, and 2) What exactly are the long-term effects on my business in terms of benefits and possible risks?
A convertible loan is first and foremost a loan--plain and simple. It involves borrowed money that has to be paid back with interest. Typically, the conversion feature gives the lender an option to convert all or a portion of the outstanding principal of the loan into some form of an equity position in the borrower's company. In its most basic form, the lender has reserved the right to exchange his or her creditor position with the company to become an owner in the company. The borrower is willing to provide the lender that option in exchange for securing more favorable terms on the loan. For example, the borrower could ask for any combination of concessions, such as: no closing costs on the deal, no prepayment penalties, a lower interest rate and/or "payment vacations" within the term of the loan. (These are often requested for strategic times when the company anticipates significant fluctuations in cash flow.)
The convertible loan allows the lender to swap a fixed dollar loan value for an equity position in the borrower's company that could be worth (over time) far more than the original loan value. Take the case of the $375,000 convertible loan at 7.5 percent interest (compounded monthly) for eight years. The borrower pays $5,200 per month, and in 96 months the loan is paid in full. The lender could have charged 9.25 percent plus $20,000 in upfront closing fees on a traditional loan, but was willing to waive the fees and drop the rate by 175 basis points. The borrower agreed that the lender could convert any outstanding principal into common stock at a preset conversion price of, say, $2.65 per share.
The lender gave up $20,000 on the front end plus more than $300 per month on the regular payments (more than $32,000 over the life of the loan). These concessions are the "price" of that convertible option "paid" to the borrower. The company may be doing very well during the fourth year, when the outstanding loan balance is $235,000. The lender has to decide: Is it more valuable to receive $5,200 per month for another four years, or should I convert this loan balance to 88,680 shares of common stock in the borrower's company? Certainly, if the lender felt that those shares could be worth around $5 or $6 per share within the next three to four years, that position would be far more advantageous than remaining a creditor and receiving monthly loan payments (perhaps $228,000 from the loan vs. more than half a million dollars as a shareholder).
Because that decision is only up to the lender, the borrower should always plan on making regular loan payments all the way until the maturity date. If the lender wants to convert, the borrower is contractually obliged to make common shares available at the conversion price in order to swap out the debt balance for equity in the firm. The firm can benefit from an exercised conversion in that a significant liability on the balance sheet is removed and the owner's equity increases representing the new shareholder stake. This improved financial position could help the borrower in securing other future deals by increasing the company's net worth.
If the lender decides to convert, it is a one-way street. Once the loan balance has been converted to equity, the lender cannot change his or her mind if the stock does not perform as per expectations. On the other hand, convertible loans can be a great win-win situation for the two parties. The borrower gets funding with some pricing concessions, and a potential windfall to owner's equity with a reduction in (or elimination of) debt at conversion. The lender gets a possible windfall in appreciated value later on with lower-risk fixed payments on the front end. Overall, convertible loans offer another creative way to secure funding for entrepreneurs willing to negotiate terms and give up some potential ownership value in the future.
David Newton is a professor of entrepreneurial finance and head of the entrepreneurship program, which he founded in 1990, at Westmont College in Santa Barbara, California. The author of four books on both entrepreneurship and finance investments, David was formerly a contributing editor on growth capital for Industry Week Growing Companies magazine and has contributed to such publications as Entrepreneur, Your Money, Success, Red Herring, Business Week, Inc. and Solutions. He's also consulted to nearly 100 emerging, fast-growth entrepreneurial ventures since 1984.
The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.