Convertible loan as an investment tool

Тtraditionally, investment transactions are realized through ordinary loans or direct investments (creation of a joint venture or purchase of a stake in an existing company). Today we will consider a difficult but interesting investment instrument – a convertible loan.

Briefly refresh what tasks classical instruments solve
Loans are used when a company (borrower) needs to finance short-term or long-term projects, and an investor (lender) wants to capitalize on this by claiming interest income. Neither the borrower nor the lender is interested in building strong corporate relationships.

Direct investments are used when a company needs serious cash injections for business development. As a rule, such a company has an understandable developing business and the owner intends to share a share in the business in exchange for investments, and the investor – to receive benefits from the increase in the value of the business.

Investing in startups
None of the classic instruments is suitable for investing in young and ambitious start-up companies, especially in the early stages of a project.

Why is that?

On the one hand, we have a startup founder who is looking for funding for his project, who has nothing to offer except a share in the business. At the same time, there is faith in the success of the idea and the expectation of financial success, but the total amount of investment required is not clear.

In addition, a startup, like any young company, may not have the financial capacity to service a loan for a long time. Debt repayment and interest payments will regularly reduce working capital, and in the early stages this will significantly affect the growth of the business.

On the other hand, an investor who plans to extract the maximum possible profit, since this justifies the high investment risks. And at the same time, the investor wants to minimize the risks of non-return of the invested money if something does not go according to plan.

It is also difficult at this stage to agree on the size of the share that the investor will receive. How to evaluate the idea and the role of this investment round in its success?

A compromise is to arrange an investment deal in the form of a convertible loan.

What is the purpose of a convertible loan?
A convertible loan, unlike classical instruments, offers several scenarios depending on the fulfillment / non-fulfillment of conditions:

The company complies with the terms of the investment deal. The investor receives shares (shares) in the company, and the loan is transformed into the capital of the company. The amount of the share that the investor receives is fixed initially or is determined by the formula described in the loan agreement.

The company does not comply with the terms of the investment deal. The investor has the right to demand the return of the loan and the payment of interest accrued from the date of the loan to the date of the actual return.

For clarity, we will give an example of the operation of the loan conversion mechanism.

Example

Ivan came up with the service “Such is Not Yet”. The lack of money to implement the idea led Ivan to seek funding. According to modest estimates, it will take 3 years and 1 million USD to reach a confident profitable level. Alexey agreed to invest in the project.

Alexey and Ivan agreed on the following terms:

The loan is provided for 3 years, the interest rate is 5% in the first three years and 25% in case of impossibility to convert the loan for reasons beyond his control;

Alexey has the right to convert the loan after three years or earlier, at the same time as attracting a new investor to the project. At the same time, the share he received in the company cannot be less than 15%.

At the end of the first year of work, the invested funds ended, but the project looks promising. Ivan is looking for a new Investor, he is the Fund, which agrees on an investment of 2 million USD, valuing the entire business at 10 million USD. The fund intends to receive 20% in the authorized capital of the company.

At this point, Alexey decides to convert the loan he provided into a share in the company. Based on the valuation of the business by the Fund, its share should have been 10%. However, the loan agreement provides for a guarantee – its share cannot be less than 15%.

Thus, the project raises a new round of investments, the Founder continues to develop the project, and Alexey receives a 15% stake in the company. Initially, it was impossible to agree on such a size of his contribution.

What are the benefits of a convertible loan?
As you probably noticed, a convertible loan can be of interest to both the investor and the founder for the following reasons:
The speed of registration, which allows you not to waste time on approvals, but to start “mastering” investment funds, conquering the market;

The investor has freedom of choice. If the business is successful, the investor can become a member (shareholder) of the invested company. If the business does not take off, the investor will return the money and receive a return in the form of interest. Or say goodbye to money, but avoid the fate of remaining a member of an inactive company;

A convertible loan increases the security of investments. The investor reduces the risks of obtaining illiquid shares (shares)b