> 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.)
Content Continues Below
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.