What Should Founders Consider Before Accepting a Convertible Loan?
Short answer. Understand when the loan converts, what triggers conversion, how the conversion price is set, and what happens if conversion never occurs. Compare the interest, repayment, maturity, and control implications with a direct equity offer. Have your attorney and CPA review the instrument and its consequences before signing.
A convertible loan combines debt terms with a possible future equity investment, so understand both outcomes before accepting it. The agreement should make clear when the loan converts, how many shares the lender may receive, and what the company owes if conversion does not happen. The structure can defer a valuation decision, but it still affects future ownership and cash obligations.
Identify the Conversion Triggers
Read the events that cause some or all of the loan to convert. Common triggers include a future financing round, a revenue threshold, a public listing, or a sale of the business. Check whether conversion happens automatically or requires an election, and whether the lender or company has any choice. The document should explain what happens if a trigger is partly met or never occurs.
Confirm how the conversion price is calculated. It may be based on the price in a future round, adjusted by a discount, or affected by a cap. Work through examples with your advisers so you understand the possible ownership outcome under different financing scenarios. A conversion cap and ownership review can help you identify the questions to resolve.
Understand the Debt Obligations
Before conversion, the instrument is still a loan. Review the interest rate, when interest accrues, maturity date, repayment requirements, and any collateral or guarantees. Clarify what happens if the company cannot repay at maturity or misses another payment. Debt is generally senior to equity, and repayment obligations can affect the company even if the business has not reached the next financing event.
Compare the cash burden and repayment risk with the proceeds and timing the company needs. A convertible loan may provide income to the lender before conversion, while offering less upside and potentially less influence than direct equity. Ask whether the agreement gives the lender any rights before conversion, and what rights apply after shares are issued.
Review the Ownership and Control Effects
Model dilution alongside any existing options, shares, and other convertible instruments. Consider whether the lender will receive voting, information, or other rights upon conversion, and how those rights could affect company decisions. Make sure the cap table reflects the conversion mechanics and the company can explain them to future investors.
Do not rely on a short term sheet to answer every question. The operative documents determine the obligations, so have your attorney review them and talk with your CPA about tax treatment. Compare the convertible structure with straight debt and equity using the company's likely cash needs, possible funding events, and ownership goals.
Read next: What terms determine whether a convertible instrument is repaid or converted? and How should a founder decide whether to raise equity, debt, or a mix of both?
Convertible debt is a loan that can be converted into equity in the future.
Sources: Richard C. Wilson solo transcripts, The Single Family Office. Informational only, not financial, legal or tax advice.