VI

This has come up on three different occasions in the past two weeks, so a brief overview ….

You can raise money for your business from getting an investment (equity) or taking a loan (debt).  Each is fairly clear.

With an investment, you sell equity in your business and the investor gets his/her return when the shares are sold.  Of course there is always the risk that may never happen.

With a loan you borrow money and are expected to pay it back over a specified period (term) at a specified interest (rate).  In theory its less “risky” than equity so earns less return to the investor.

A convertible loan is a hybrid instrument, that always starts out as a loan, but may be converted – at the lenders discretion – to equity.

Let’s suppose you needed $100,000 and that was best suited to a loan.  You could look at a “straight” loan (as opposed to a convertible loan) which would come with a repayment schedule (term) and interest (rate) attached.  Let’s say, for illustrative purposes, that the terms of the straight loan were 8% APR over a five year period.

A convertible loan would give the lender the ability to “convert” any of the unpaid principal into shares in the business at an agreed share price.

Why would the borrower or lender want to do that?

First, the lender.  Perhaps he/she would like “a piece of the action” – equity – but for a number of reasons isn’t willing to jump in with a straight investment.  Those reasons could include their intolerance to risk.  By using a convertible loan, they get their cake and eat it too.  The risk is reduced (in theory) and they can jump in with equity if they decide.  That’s a good option to have.

From the borrow’s side. He/she is giving up something here, by giving the lender the right to convert.  That’s worth something.  In general the value prepresented by the right to convert on the lenders side, is matched by better loan terms for the borrower – usually reduced interest rate or more favorable general terms.  In this case, the convertible loan may look like; $100,000 borrowed at 6% over a seven year period, with the unpaid principal converting to shares at $5/share.

Et voila.

/d

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