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What is a convertible loan?
Convertible means that the company and/or the lender has the right to convert the remaining balance of the unpaid loan into equity at an agreed-to price per share. The type of equity (e.g., common or preferred, and if preferred, then what class) is agreed to in advance. The price is either one that is agreed to by both parties at the loan origination date or is the current market value of a share of the company's stock at the time of conversion.
Sometimes, a convertible loan automatically converts to equity upon closing the next round of investment at the price of that round. In any case, when the loan in converted into equity, the loan is cancelled (i.e., considered paid off) and the lender becomes a shareholder.
Notice that adding conversion capability to a loan gives a lender maximum flexibility, i.e., if the company does poorly, being a creditor gives the lender a better chance of being paid something, but if the company does well, the lender can become a shareholder and enjoy larger potential returns.
In addition, because the lenders are “investing” their money earlier than the other investors, the deal is sometimes “sweetened” in one of two ways:
- They are offered the equity at a discount of, say 10% to 25% off the price that other investors are paying, and/or
- They are offered warrants, i.e., they are given the right to purchase additional shares in the future at the price of the investment round.
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