Starting your own startups can be one of the most fulfilling things to do.
The pros of a startup are very enticing such as being your own boss, doing what you love and making your own schedule.
However, for how fun a startup can be, it can also be very stressful. One of the more stressful parts is finding a way to fund your startup. A startup can only last so long on your own personal money, after that you and your team will have to accumulate funds through someone or something else.
Examples include startup competition, investments or loans from friends and family, VC investing, and other ways. When it comes to loans from another person or company it is important to know how these loans are going to work. In this post, I will talk about one of the more popular types of loans, a Convertible Loan.
What is a Convertible Loan?
A convertible loan can be understood as a loan turning into an investment contingent on certain conditions. A convertible loan starts out as borrowed money that has to be paid back with interest.
Where the convertible loan is different is when there are stipulations added to the contract that when passed turns the loan into equity. Stipulations could range from the startup hitting a certain valuation, meeting certain sales or profit targets or on demand.
The way the loan is turned into equity is predetermined and written into the agreement. Along with the stipulations being predetermined, the price at which the loan turns also has to be decided as well. The general practice is to use the valuation of the startup at the time of signing the agreement.
Who Decides the Terms?
The ability to turn the loan into equity belongs solely to the lender so he or she can do so whenever they please. You might be thinking why would I agree to give that option to them, the reason being that agreeing to that clause gives your startup much more beneficial terms for the loan.
Common examples are lower interest rates, no closing costs, lesser late fees etc. Since the ability to turn the loan rests with the lender, it is smart for the startup to expect to have to make payments all the way till the end of the loan.
Here's an example that illustrates the whole concept
An investor contacts you about investing in your startup, he proposes a convertible loan (your startup is valued at $5 Million). His offer consists of a $50,000 loan for which he will lower the interest rate to 5% and also lower late fees. Payments are scheduled to be monthly till the loan is paid off.
As your startup grows, the lender has the ability to turn whatever money that has not been paid back yet into equity at the $5 Million valuation. So if your startup is now worth $50 Million the lender would definitely convert his loan into equity, however if your startup stalls, the lender will most likely continue with the loan situation. If the lender decides to convert the loan into equity that will be final, the lender will not be able to take back his decision.
In essence a convertible loan can be beneficial to borrowers and lenders in the right situation. Borrowers can benefit from lenient loan terms, in exchange for relinquishing ownership stake. Similarly, lenders who are flexible their loan expectations could turn profit from the increased value of equity.
How can a Business Lawyer Help?
A business lawyer can help draft and review your convertible loan agreement to prevent any problems in the future.
Are you a startup or an entrepreneur? We can help with your legal needs.
Mollaei Law is a startup law firm serving startups and entrepreneurs. We can help with all of your business needs including tailoring legal documents for your business, reviewing and drafting contracts, negotiating, business planning, setting up business entities, and helping with any of your business transactional forms.
For more information, visit www.mollaeilaw.com or contact Sam Mollaei, business lawyer, at [email protected] or via phone at (818) 925-0002.
