Convertible loan

What it means

A convertible loan is investor money that turns into equity at the next round. It postpones the valuation question to a moment when there is something to base it on.

The terms are set in a term sheet: the discount to the next round’s price, a valuation cap, interest, and what happens if no round comes.

It differs from an ordinary shareholder loan in its purpose: the investor is not waiting for principal and interest back but for a stake. Interest is therefore often not paid out but added to the principal and converted into equity along with it; repayment is only the fallback scenario.

How it works in practice

Until conversion the books show a liability, not equity. That worsens the gearing ratios a bank looks at, which is worth planning for before a loan application.

Conversion runs as a capital increase set off against the investor’s claim. In an s. r. o. that means a notary and a register entry; in a simple joint-stock company, issuing new shares.

Before signing we model with the client how the cap table will look after conversion at different valuations of the next round. The founders see how much of the company they keep if the round comes earlier or later and at a lower price than they expect, and judge the discount and cap on actual numbers.

What to watch out for

A loan from a member who is also a director has a tax dimension: the interest falls under transfer pricing rules and may not be repaid while the company is in crisis.

If the next round does not happen by the agreed date, the contract either converts the loan at a price fixed in advance or makes it repayable. The second option can push a company without cash into insolvency, so that clause deserves the same attention before signing as the discount and the cap.