What is Convertible Debt as a Method of Quick Access to Finance?

There is no doubt that gaining access to investment is crucial for startups, but equally vital is accessing it swiftly. In investment rounds, parties must agree on both the company’s valuation and lengthy investment agreements, which often prolongs the process. Valuing startups, particularly in their early stages, is challenging, yet determining the company’s value is essential to initiate the investment round. Consequently, closing investment rounds within six to twelve months can pose a challenge for cash-strapped startups, necessitating faster financing solutions for survival. Convertible debts have emerged as one such solution to address this need.

Typically, those who lend convertible debts to a startup are individuals already interested in investing in the company. These lenders provide funds to cover the startup’s urgent cash needs, particularly in its early stages, and, in return, receive a stake in the company under more favourable terms in the subsequent investment round. Furthermore, convertible debts do not require a valuation.

So, what are the advantages of convertible debts for these individuals who extend support to founders by lending money without collateral, especially in the high-risk early stages? The benefit to lenders often includes a discount on the company’s value in the next investment round, and in some cases, a valuation cap on top of this discount. We’ll delve into this further below.

Before proceeding, it’s worth noting that the convertible debt mechanism is not regulated under Turkish law. However, startups in Turkey, like their counterparts worldwide, require quick and practical financing solutions. Therefore, parties can utilise this mechanism within the framework of the principle of freedom of contract.

Discount on the Valuation:

The hallmark of convertible debts is that the creditor (investor) gains the right to acquire shares in the company in exchange for the receivable. These investors, who support founders and take risks when no one else does, naturally have expectations. What makes this loan attractive to investors is the discount they receive on the company’s value. Thanks to this discount, investors pay a lower price per share than those who join the company in the subsequent investment round. This can be better explained through an example.

Example 1:

Company X is a joint stock company founded by three founding partners (A, B and C) with a capital of TL 250,000. The company’s capital is divided into a total of 250,000 shares with a nominal value of TL 1 each.

Investor 1 is entitled to a discount of 20% in the next investment round in return for a convertible loan of TL 120,000 to Company X.

The investment round was completed with a total investment of TL 1,000,000 by Investor 2 at a pre-money valuation of TL 5,000,000.

The price per share paid by Investor 2: TL 5,000,000 (company value) / 250,000 (total number of shares) = TL 20

The price per share paid by Investor 1: (TL 5,000,000 - (TL 5,000,000 x 20 %)) / 250,000 = TL 16

Total number of shares held by Investor 1: TL 120,000 / TL 16 = 7,500 shares (without discount: 6,000 shares)

Total number of shares held by Investor 2: TL1,000,000 / TL 20 = 50,000 shares

Valuation Cap:

The discount applied to the valuation in the next investment round might not always meet the investor’s expectations. There’s a risk that the company’s value resulting from the discount on the valuation could surpass the price the investor would have paid had they opted to purchase shares in the company instead of loaning money. Consequently, some investors demand a valuation cap in addition to the discount. Even if the investment round concludes at a valuation higher than the valuation cap, the investor enters the company based on the valuation cap. In simpler terms, the valuation cap sets the maximum price at which the convertible debt can be converted into shares.

Example 2:

Company X is a joint stock company founded by three founding shareholders (A, B and C) with a capital of TL 250,000. The company’s capital is divided into 250.000 shares with a nominal value of TL 1 each.

Investor 1 is entitled to a 20% discount in the next investment round in exchange for a convertible loan of TL 120,000 to Company X and a valuation cap of TL 3,000,000 is set.

The investment round was completed with a total investment of TL 1,000,000 by Investor 2 with a pre-money valuation of TL 5,000,000.

The price per share paid by Investor 2: TL 5,000,000 (company value) / 250,000 (total number of shares) = TL 20

The price paid per share paid by Investor 1: TL 3,000,000 (valuation cap) / 250,000 = TL 12

In Example 1, Investor 1 was only entitled to a discount and the price per share paid with this discount was TL 16. Since there is also a valuation cap in this example, Investor 1’s debt convertible into shares is more favourable than the discounted debt.

An important consideration for founders is that setting the valuation cap too low may not sit well with investors in the subsequent investment round. Consequently, investors may be inclined to accept the valuation cap outlined in the convertible debt agreement as the company’s value for their own investment. Given that this valuation cap can impact the company’s valuation, even indirectly, it’s beneficial for founders to avoid setting the cap too low.