If you are thinking of making an investment in a business, then providing a loan or investing in shares is usually the first thing that comes to mind. In practice, we are also increasingly seeing a hybrid form of these two forms of investment; the convertible loan. Especially startups are financed with convertible loan, but more and more "mature" businesses are also choosing it.
At its core, the convertible loan boils down to the following; the investor provides the business with a loan, and that loan can be converted into shares in the business (the conversion) by the investor at a predetermined time (the conversion moment). So in the conversion, the business does not repay the loan, but in return issues shares to the investor at the agreed conversion ratio. Venture capital then becomes equity and the investor, who is thus first a lender, becomes a shareholder.
This convertible loan is a serious alternative to making an equity investment. But as with any form of investment, the convertible loan also has drawbacks. Below I list some important advantages and disadvantages of the convertible loan for both the investor and the business, especially compared to a direct equity investment.
Business pros and cons.
Advantages
- Especially in the startup phase, it is difficult to value the business. Sometimes the business at that time is little more than an innovative idea. When taking out the convertible loan, the business does not yet have to be valued. After all, only a loan is provided. Valuation only occurs at the conversion time.
- Taking out a convertible loan is usually faster, easier and cheaper. So not only can the valuation discussion be moved along, but the documentation required for a convertible loan is usually simpler. Furthermore, a notary is not required and the investor usually does not do any bookkeeping (due diligence) or only limited due diligence prior to making the convertible loan.
- Until the conversion moment, the business usually does not repay the convertible loan and accumulates the agreed interest with the convertible loan. If conversion takes place, there is no cash out for the business at all.
- In principle, when taking out the convertible loan, the business does not lose control. Until the conversion moment, the investor has no shares and therefore no control rights associated with them.
Disadvantages
- Often conversion is a right of the investor and not an obligation. So it may happen that the business thinks the investor intends to convert, but the investor ends up simply claiming the convertible loan.
- The time savings gained from taking out a convertible loan are partially cancelled out with conversion. If conversion takes place, a notary is required and a shareholder agreement is often drawn up.
Advantages and disadvantages investor
Advantages
- Conversion usually occurs at a price lower than the market value of the business at the time of conversion. The investor acquires the shares at a discount.
- If the business goes bankrupt and has not yet been converted, the investor has a higher rank compared to the shareholders. The investor is then more likely to see a return on his investment.
- The convertible loan can be secured by security rights. Think of a lien on assets of the company.
Disadvantages
- Against some advantages for the business, there are disadvantages for the investor. Until conversion, the investor often receives no return on his investment and the investor basically has no control over the business.
