Convertible Loan vs. Equity Round

1. Direct Entry into the Company

Typical for investment rounds at a later stage.

The traditional way of entering into a company is to acquire a share.  This approach requires the preparation of more extensive corporate documentation, costs more and takes longer. On the other hand, both parties know what they are getting into. Direct entry is mostly used in the later investment rounds (from Series A onwards). In the CEE region it is also often used in an Angel round.

2. Convertible Loan

The most common form of investment designed for startups.

It is a cash loan entitling the creditor to exchange (convert) the loan for a share in the company. This type of investment is faster and cheaper, as the investor does not become a shareholder in the company until the moment of conversion (a moment 18 to 24 months after the grant of the loan).

The Main Advantage

A bet on the future value of the startup will allow the founders to keep more equity in the company.

The convertible note is an inconspicuous creator of the entire startup ecosystem. It simply wouldn’t have come into being without it. If the startup received investments at the current (typically low) valuation, the founders would either not be able to accept a high investment (so they would not help themselves much) or they would be too diluted in the first rounds and would not be left with any equity for other rounds. This Catch-22 is dealt with by the convertible loan by the parties agreeing on a future investment valuation, which the startup should have in 18 to 24 months. This often exceeds the current valuation by more than 100%. This valuation allows the founders to obtain a higher investment by losing a smaller part of the equity. Other aspects of the convertible note are discussed in the manual HERE.

Reality of the CEE Region

In the CEE, a convertible note often becomes complicated in favour of the investor.

In our region, some of the benefits of a convertible note are lost through the aggressive behaviour of some investors. This happens mainly in 2 areas:

  • Corporate structure: In the seed investment round, investors typically require the establishment of a supervisory board, where they have an absolute majority. This then approves all important steps of the company (e.g. the entry of a new investor). Such a setting slows down the entire transaction, as well as the further operation of the startup. This is in stark contrast to the practice in the West, where the supervisory board is either not established at all or investors acquire only a minority control in the seed round.

  • Valuation: Some investors undermine the purpose of a convertible loan by associating the loan with high interest rates (sometimes above 10% p.a.) as well as a high discount (above 30%) on conversion.