Starting a business is an exciting journey, but securing the right funding can feel overwhelming. For a flexible financing option, consider the convertible loan agreement startup strategy—for entrepreneurs wanting to grow without immediately giving away equity.

Convertible loans offer startups a strategic advantage by bridging the gap between debt and equity financing. Unlike traditional loans that demand immediate repayment, convertible loans provide a flexible funding option that aligns with the unpredictable nature of early-stage ventures. By deferring valuation and offering potential equity upside, these instruments empower startups to focus on growth and innovation without the pressure of immediate financial obligations.

Also read: Does Your Company Have the Right Capital Mix?

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What is a Convertible Loan?

Convertible debt (also called convertible notes) is a form of financing that is often used by high-growth, early-stage companies. It starts off as a loan (debt), but the lender and the company have options to convert the debt to equity under certain predetermined terms called “conversion privileges” as specified in the deal’s term sheet. Under such an agreement, the lender generally does not place a valuation on the borrowing company, meaning the current or future value of the company might not be taken into account when the loan is being made. However, in many circumstances, a valuation cap (ceiling) is included in the terms. The lender may add other specific clauses to the note that they would require when and if they become a shareholder.

For example: your startup is on the verge of a breakthrough but needs immediate cash to seize a market opportunity. Setting a company valuation feels premature, and you're wary of diluting your ownership too soon. A convertible loan steps in as the perfect solution, providing the funds you need now while deferring the valuation and equity conversion to a future financing event.

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Key Terms Related to Convertible Loans

Convertible loans are typically mid-term loans with a maturity period of 18-36 months. Understanding the key terms associated with convertible loans is crucial for both startups and investors. Here are the main terms you need to be familiar with:

1. Principal Amount: The principal amount is the initial sum of money that the startup receives from the investor. This amount is treated as a loan and is recorded as debt on the startup’s balance sheet. It is intended to be converted into equity during a future funding round or repaid at an agreed-upon date if the conversion does not occur.

For example, if an investor lends a startup INR 10,00,000 through a convertible loan, this INR 10,00,000 is the principal amount.

2. Interest Rate: The interest rate on a convertible note determines how much interest accumulates before the note converts to equity or is repaid.

Example: With an 8% interest rate on a convertible note, an INR 10,000 investment would grow to INR 10,800 if the note converts after one year. 

3. Maturity Date: The maturity date is the deadline by which the convertible loan either converts into equity or is repaid as a loan with any accrued interest. 

For instance, if a convertible loan has a maturity date of 24 months, the startup must either convert the loan to equity or repay the principal amount with interest within this period.

‍4. Discount Rate: The discount rate is a key incentive for early investors. It is the percentage by which the convertible loan's conversion price is reduced compared to the price paid by new investors in future funding rounds. This means that early investors get shares at a lower price, providing them with an additional benefit for taking on early-stage risk.

For example, if the discount rate is 20% and the new investors pay INR 100 per share, the convertible loan holders would convert their loan at INR 80 per share.

5. Valuation Cap: The valuation cap is the maximum company valuation at which the convertible loan will convert into equity. It ensures that early investors are rewarded with a favorable conversion price, protecting them from overpaying if the company’s valuation significantly increases.

For example, if a convertible loan has a valuation cap of INR 50 million, and the company is valued at INR 70 million during the conversion, the investor’s conversion price will be based on the INR 50 million cap.

6. Conversion Price: The conversion price is the price at which the convertible loan converts into equity shares. It is determined by the future round valuation or the valuation cap/floor and includes any applicable discount. The conversion price dictates the number of shares that the investor receives for their initial investment.

For example, if an investor holds a convertible loan for INR 1,000,000 with a 20% discount and the next round valuation is INR 100 per share, the conversion price would be INR 80 per share, giving the investor 12,500 shares (1,000,000 / 80).

Understanding these key terms helps in structuring a convertible loan agreement that aligns the interests of both startups and investors, providing clarity and fairness in the financing arrangement.

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Advantages of Convertible Loans for Startups

1. Quick Access to Capital: Convertible loans are a faster way to secure funding compared to traditional equity financing. This is crucial when you need to act quickly to capture market opportunities or meet operational needs. 
2. Flexible and Simple Contract Structure: These loans often come with straightforward terms and conditions, making the negotiation process smoother and less time-consuming. This simplicity can be a significant advantage when you need to focus on running and growing your business.
3. Deferred Equity Conversion: One of the biggest benefits of convertible loans is the ability to defer equity conversion. This means you can delay the dilution of your ownership until a later date, typically when your startup is in a stronger position to negotiate terms.
4. Low Costs for Contract Drafting: Compared to the complex legal documentation required for equity financing, convertible loan agreements are generally simpler and less expensive to draft. This can save your startup valuable time and money.

With Recur Club, you can save time by getting capital offers from over 100 lenders with just one application. Enjoy absolute transparency with no hidden charges and easy-to-understand capital terms. 

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Challenges of Convertible Loans for Startups

1. Potential High Discount on Future Valuation: Startups might face a higher discount on their future valuation during conversion, which could lead to significant dilution of ownership.
2. Limited Contributions from Lenders: Unlike equity investors, lenders may not be as involved or provide as much support to the startup beyond the financial loan.

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Convertible Loan vs. Equity

Key Components of a Convertible Loan Agreement for Startup

1. Loan Agreement Details: This section outlines the terms of the loan, including the amount, interest rate, repayment schedule, and maturity date. It also includes any fees associated with the loan.
2. Conversion Conditions: This includes the rights of both the startup and the investors, the formula for calculating shares upon conversion, the discount rate applied to the conversion, and the valuation cap that protects the investor.
3. Investor Rights: Details the rights of investors, such as participation rights in future financing rounds, access to company information, and preferences in case of liquidation.
4. Subordination Clause: Specifies the priority of the convertible loan in case the startup becomes insolvent. This clause ensures that the convertible loan is subordinate to other debts.

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Steps to Raise a Convertible Loan 

Step 1: Register with DPIIT 

Register your startup with the Department for Promotion of Industry and Internal Trade (DPIIT). This registration is mandatory for any startup in India seeking funding through a convertible loan.

Step 2: Understand the Regulatory Guidelines 

Raise a minimum of INR 25 lakhs in a single tranche to meet the requirement. According to the Foreign Exchange Management Act (FEMA) of 1999, you can issue convertible loans to foreign investors. Ensure compliance with all relevant laws and regulations.

Step 3: File Relevant Documents 

File the necessary documents, including board meeting resolutions and shareholder agreements, with the Registrar of Companies (ROC).

Step 4: Review and Finalize the Convertible Loan Agreement

Draft and review the convertible loan agreement. This binding document serves as the basis for negotiation between you and the investor. Include details like the conversion trigger event, maturity date, discount rate, valuation floor or cap, and investment conditions.

Step 5: Negotiate with Investors 

When raising a convertible loan, the negotiation process between startups and investors is crucial. This stage involves agreeing on key terms such as the interest rate, maturity period, conversion triggers, and discounts. These terms are critical as they directly impact the startup's future financial obligations and the investor's potential returns.

• Interest Rate: The startup issuing the note will pay the investor or note holders this interest on the principal amount.
• Maturity Period: This sets the timeline by which the loan must convert to equity or be repaid. A longer maturity period offers more flexibility to the startup, while a shorter period provides quicker returns for the investor.
• Conversion Triggers: These are the specific events that trigger the conversion of the loan into equity, such as reaching a certain valuation or closing a new funding round.
• Discount Rate: The discount rate provides an incentive for early investors by allowing them to convert their loans into equity at a reduced price compared to new investors.

Successful negotiations ensure that both the startup and the investor have aligned interests, paving the way for a mutually beneficial relationship.

Step 6: Receive Funding

Once the convertible loan agreement is finalized and all formalities are completed, the next crucial step is the actual disbursement of funds. Typically, the investor transfers the agreed loan amount to the startup’s designated bank account. This inflow of capital is a significant milestone, as it provides the startup with the necessary resources to fuel growth, scale operations, or capture market opportunities.

Alteria Capital and InnoVen Capital are some of the platforms in India that offer financing options to startups. 

Step 7: Meet Reporting Requirements after Issuance of Convertible Notes

Under RBI :

1. FIRMS Portal Registration: Create a Business User account and Entity Master account on the Foreign Investment Reporting and Management System (FIRMS) portal to initiate compliance processes.
2. Form CN Filing: Submit the convertible notes form within 30 days from receiving the payment in the bank account. This form is essential for reporting the issuance of convertible notes to foreign investors.
3. Supporting Documentation: The following documents are required:

• Certificate from CA/CS: Certifying compliance with FEMA regulations.
• FIRC and KYC: Foreign Inward Remittance Certificate and Know Your Customer documents from the bank.
• Convertible Notes Agreement: A signed copy of the agreement outlining the terms of the convertible note.

Under Companies Act, 2013:

1. Approval: Obtain approval from the company's members via a special resolution at the General Meeting. This approval is a legal prerequisite for issuing convertible notes.
2. Registrar of Companies Notification: File eForm MGT-14 with the Registrar of Companies within 30 days of the General Meeting. 

This detailed process ensures that both the regulatory and legal aspects of issuing convertible notes to foreign investors are thoroughly addressed, minimizing the risk of non-compliance.

Also read: The Cost of Capital: Comparing Debt and Equity for Startup Growth.

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Conclusion

Convertible loans are a dynamic financing tool offering a balanced mix of debt and equity. They provide rapid, flexible capital without needing an immediate valuation, making them ideal for startups at various growth stages. While they come with their challenges, the benefits often outweigh the drawbacks for startups. 

By understanding the intricacies of convertible loans, you can make an informed decision that aligns with your startup’s unique needs and growth trajectory.

And when you're ready to explore your financing options, trust Recur Club to help you secure the best capital offers. Contact Recur Club today and let us help you focus on running your business while we handle your fundraising needs.

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