There is a point when, as an angel investor, you have to sit down at a negotiation table to seek agreement with the startup founders on the terms for your investment.
And there are some really difficult issues to discuss, for instance:
– valuation or how much of the company will you own after the investment;
– liquidation preference or what will you get in the case the company is liquidated and how will you rank compared to other financiers;
– anti-dilution or your right to maintain the ownership percentage in the event that new shares are issued;
– pro rata or the right to participate in the next financing rounds to maintain the level of ownership in the company.
For early stage investments it is often better to postpone this discussion to later stages of the startup’s lifecycle and to structure the investment as a convertible loan. Such loan comes with an embedded feature of converting into equity at some future date. The financial instrument is designed and structured as a loan but it is implied that it is not expected to be repaid.
Avoiding discussing the most difficult investment aspects does not mean that there is nothing left to negotiate about a convertible loan. There is still a number of things to talk about:
– size of the qualified financing round that will trigger conversion (it should be a meaningful contribution of fresh external capital);
– discount on share price at which the loan converts to equity (to compensate the investor for taking an early investment risk);
– valuation cap that establishes the maximum value at which the conversion can take place irrespective of the valuation at which the qualified equity investment is made;
– interest rate that accrues on the convertible loan until conversion;
– maturity date at which the loan will convert into equity even if there was no qualified financing round;
– change of control actions spelling out what would happen if the startup gets acquired before the qualified financing round.
Convertible loan is an instrument that allows for relatively quick execution compared to an equity investment, but there are certain issues to keep in mind:
– investor holding a convertible loan is not yet a shareholder;
– he/she has no voting rights;
– no shareholder protection applies to the lender.
This suggests certain things for an investor to consider when negotiating the convertible loan terms:
– insist on similar rights to a shareholder on issues like information rights and access to and pro rata rights;
– application of the “most favoured nation clause” in case of subsequent convertible loans being raised (ensuring that you will receive same favourable treatment as any other convertible loan provider negotiates with the company at a later stage);
– pay attention to the conversion scenarios and strive for specifying all the possibilities;
– remember that most of the convertible loans will get renegotiated at some point.
Let’s look at hypothetical example of how a convertible loan works in practice. You have agreed to invest EUR 50,000 as a convertible loan with a maturity date in 18 months, interest rate of 10% a year, discount of 25% and a valuation cap of EUR 5 million. The qualifying financing round is agreed to be at least EUR 500,000.
After 12 months the amount to get converted is your original investment together with the interest accrued, or EUR 55,000. The company is finalising an equity round of EUR 1 million (this size makes it a qualified financing) at a pre-money valuation of EUR 4 million. The valuation of the equity round is lower than your valuation cap (which was EUR 5 million). In this case the discount at conversion is applied to the EUR 4 million pre-money valuation.
In a different scenario the equity round could be based on, say, EUR 6 million valuation. Since this is higher than your valuation cap, the conversion will take place at EUR 5 million, less the 20% discount, or at EUR 4 million.
It may happen so that there is no qualified financing round during the time period the loan is outstanding. Usually in such a case the conversion gets completed at a maturity date at the valuation the company had in the previous equity round. It gets more complicated in cases when convertible loan has been the first outside financing raised by the startup (which is the more common situation for angel investors). Unless parties have addressed such a situation in their original agreement, or course.
With so many moving parts to consider and to negotiate it is critical for an investor to remain calm and level-headed. As Naval Ravikant once cautioned: “Investing favours the dispassionate. Markets efficiently separate emotional investors from their money”.
This note was first published on Medium.com on 28 October 2023.
