So, you’ve heard about Convertible Loan Agreements (CLAs), right? Or maybe you’ve come across the term convertible loan. In simple terms, it’s a legal agreement between an investor and your startup (or you, the founders) where an investor gives you money now in exchange for the option to either convert that loan into equity later or get the cash back with interest.
Sounds straightforward, right? Well, kind of. But let’s break it down a bit more.
What Happens if the Investor Doesn’t Convert?
If the conditions for converting into equity aren’t met and the investor decides to take their money back instead, it’s just like a regular loan. The catch? Your startup has to have the money to repay it. But what happens when the conditions are met, and the investor chooses to convert? That’s when the real venture journey begins, and we’ll explain what happens next.
What’s a Convertible Loan Anyway?
In a typical equity investment, an investor gives you money in exchange for an immediate ownership stake in your company. This means they get a share of control, a cut of future profits, and a piece of the pie when you eventually sell the company (exit). The exchange of money for ownership happens right away, based on your company’s current valuation.
But a convertible loan (CLA) lets you delay the discussion about how much equity the investor gets until a time when your company’s valuation can be determined more accurately. The beauty of this is that neither you nor the investor have to argue over valuation right now, which often avoids a lose-lose situation (where the investor thinks they’re giving too much, and you think you’re giving too little). A CLA lets you get the cash upfront without needing a solid valuation at the start—but that doesn’t mean no valuation is set at all.
Why Do Startups Love CLAs?
One of the biggest reasons startups opt for convertible loans instead of equity investments is that they’re faster and cheaper to execute. You can usually close a CLA in just a few weeks because the document is short and sweet, and you don’t need a deep-dive legal audit. Compare that to an equity investment, which can take months to wrap up. Plus, a CLA is easier on your wallet, with typical legal fees running much lower (think hundreds or few thousands of Euros).
Of course, it’s always a good idea to have a basic term sheet in place before negotiating the CLA. This outlines the key commercial terms, saving time and money on both sides.
A Win for Investors Too
CLAs offer investors a nice little fallback—they can choose to have their money returned with interest if they’re not feeling the love for your startup anymore. However, investors who push this right too hard can scare off founders. Why? It shows they don’t really believe in your startup and are more interested in getting their money back with interest. Not exactly a confidence boost for you, right?
Should Investors Always Have the Option to Choose?
Here’s the big question: Should the investor have the right to choose between getting their money back or converting to equity? Or should the CLA be structured so that if the conditions for conversion are met, the investor has to convert?
It’s a bit of a philosophical question, but we lean towards the latter. Once the conditions for conversion are met, the investor should get a stake in your startup—no take-backs. In our experience, investors are in it for the long haul, aiming to monetize their investment when you exit (hopefully for a nice multiple of their initial investment). They’re not in it to just earn a small return on their loan.
Another thing to consider: by the time the conversion conditions are met, your startup has probably already spent the loan. If you had to start repaying previous investors, it would hurt your ability to keep growing. That’s definitely not the goal of the investment process!
When and How Does the Convertible Loan Convert to Equity?
The conversion happens during something called a “conversion event.” This typically occurs during a qualified investment round (usually Series A), when the investor swaps their loan for a piece of your startup. At this point, your company’s valuation can be determined, and the investor’s share of equity is calculated. While this usually happens at Series A, it could also happen earlier, during a seed round.
If you’re curious about the investment process or the types of agreements used during investment rounds, check out our other blog posts!
Unlike traditional loans, where interest might be paid periodically, CLA interest accrues and gets added to the principal at the time of the conversion. A simplified version of the final calculation looks like this:
Investor’s share (%) = AVN / Valuation ≤ €2 million * 100, where:
- “AVN” is the current outstanding loan plus accrued interest, and
- “Valuation” is the post-money valuation achieved in the qualified round, with a cap of €2 millions for this investor.
Conversion Discount and Valuation Cap—Investor’s Best Friends
At this point, you might be thinking that the only difference between an equity investment and a CLA is the timing of the equity transfer. But there’s more. Since CLAs are typically used in early-stage rounds (pre-seed or seed), investors take on significantly more risk. And with that risk comes reward in the form of two things: (i) a conversion discount and (ii) a valuation cap.
A conversion discount gives the investor the right to buy equity at a discounted price compared to the valuation in the qualified round. This means they get a larger slice of the pie than if they had invested during that round. The typical conversion discount is 20% to 25%. Some deals may even let the discount grow over time, e.g., by 1% per month after signing, up to a maximum of 25%.
A valuation cap, on the other hand, puts a ceiling on the valuation of your company when the investor converts their loan. If your startup’s valuation exceeds this cap, the investor still converts at the capped value, which means they get a bigger equity stake.
Beware of Liquidation Preferences and Full Ratchet Clauses
Investing through a CLA doesn’t always end with conversion or repayment. Sometimes, things go south, and the startup shuts down. In that case, it’s not unusual (though not standard) for an investor to ask for their money back, plus interest. If there’s anything left after liquidating assets and settling debts, the investor gets what’s left—leaving founders with nothing.
Another non-standard clause you might encounter is the full ratchet clause. This protects early investors from dilution in later funding rounds. If your company’s valuation drops in a future round, a full ratchet clause could force you to give up more equity to make up for the difference, which could harm your long-term motivation.
We’ll cover liquidation preferences and full ratchet clauses in more detail in a future blog because these are critical issues for founders to be aware of.
What About a Regular Loan Instead of a CLA?
So, now you know what a CLA is and how to approach negotiating one. But you might still wonder: Should I just take out a regular loan and skip the whole conversion thing?
The simple answer is that most startups won’t be able to get a regular loan, especially from a bank. Banks typically require collateral (guarantees, liens, etc.), which most startups and founders just can’t provide. Even if they can, it doesn’t hold much value as collateral.
Sometimes, you might see bridge financing—essentially a short-term loan to help a startup get from one funding round to the next (e.g., from seed to Series A). This kind of financing is usually provided by existing investors and is often structured as a CLA.
That’s the lowdown on convertible loans! If you’re navigating the world of startup funding, understanding CLAs can help you secure the right deal to fuel your growth.
