Turkish Law Blog
Convertible Loan and Convertible Equity Agreement for Angel Investors and Startups
We are getting much more exposed to the term ‘startup’ than the past. It would not be wrong to say that startups and their newly established culture are composing a new era and they are being more attractive day by day. However, what is the definition of ‘startup’? This question could be seemed simple, but it is one of the toughest questions to answer. When we look at the simplest definition, “A startup is an entrepreneurial venture which is typically a newly emerged, fast-growing business that aims to meet a marketplace need by developing or offering an innovative product, process or service“. If we answer that question with this simplest definition another recent and trendy question will pop-up. “Joining a mature company or working for a start-up company?” In these days, the number of people whose respond is ‘yes’ to this question is increasing drastically.
Putting some disadvantages aside, it is obvious that there are so many reasons for being eager to work for start-ups such as share options, task diversity, challenging environment. On the other hand, the employees are not the only subjects who want to be part of this new culture, but also investors are showing their eagerness to be part of those startups through investing significant amount of money to the promising ones. The underlying reason of replacing conventional trade practice with new ones is new notion of investors which provided by latest technological and technical developments.
Beyond this, most of the governments also support the entrepreneurs and startups by releasing the investors from some tax obligations. (You may check out - SEIS – EIS in UK and BAFA in Germany) Of course, these incentives encourage the investors on their supports to the startups.
As we mentioned above, it is obvious that startups composing a new era and they need investors to continue what they intended to do. This fact reveals an inevitable question; “What kind of legal instruments can serve an investor while investing money to mostly instable and new companies or entrepreneurs?”. Of course, there is a wide variety of investment structures available but in this paper, we will try to explain convertible loan and convertible equity which are mostly used by the investors while they are investing to startups.
Convertible Loan Agreement and Convertible Equity Agreement
The difference between convertible loan and convertible equity basically is the presence of a ‘loan’. If a convertible loan agreement is signed between a startup and an investor, it means that the startup will be obliged to repay the agreed amount of money with its interest to the investor where the company cannot handle the following rounds so that the loans do not convert into equities. On the other hand, if the startup company goes well and proceeds to the next round, the loan will be converted into the equities and the things will be in order. Actually, taking the quick money requirements of the startups into consideration, convertible loan agreements are useful because it reduces the time spent on negotiation about documentation as the convertible loan agreement is a plain and simple document. Besides that, due to signing a convertible loan agreement will not make the investor one of the company shareholders until the loan is being converted into the equity at the next round, the investor will not have shareholder rights such as having a vote on corporate matters and this is also an advantage for the startups. If we review a convertible loan agreement, we will see many common terms in most of them as follows:
- Maturity Date – Maturity Date is one of the biggest and stressful burden on startups which was brought by convertible loan agreement. The investor can request its investment back given to the startup when the maturity date comes where the investor has its own reasons not to trust the startup company’s future. If this is the case, the startup company has to pay the investment back to the investor plus its interest. Unfortunately, this could be really exhaustive in terms of the startup, in particular, where the company is not in a position to pay the money back.
- Interest Rate – A convertible loan agreement always has an interest rate as the leading issue of the agreements is ‘loan’. We barely come across with convertible loans with no interest rate, but you should bear in mind that it is quite possible having a trouble with the tax authority pursuant to your local law. As we told before, if everything goes well and the startup proceeds to the next round, the loan will be converted into equities. If this is the case, the interest will be charged over the main loan and the equities will be calculated with the consideration of interest and main money.
- Conversion and Valuation Cap – A convertible loan agreement has been signed between the parties, everything went well for the startup and it is time to convert the loan into the equities. How this procedure should be carried out? In order to answer this question, in the agreement, there should be a part about the conversion itself. Generally, the conversion procedure depends on the ‘qualifying financing’ in a convertible loan agreement. For example, your convertible loan agreement will require a precise amount of money which the startup should make and when the company reaches that amount -qualifying financing- the convertible loan will be converted into the equities. As you may see, it is quite important part of the convertible loan agreement. Furthermore, it is not obligatory but sometimes there could be another term on the convertible loan agreement which is ‘Valuation Cap’. Where the convertible loan is ready to be converted into the equities, firstly, the parties have to calculate the money with its interest. Sometimes there could be a cap on the agreement which limits the total money with a specific amount and at the time of conversion, the parties have to take this cap into consideration.
As we told above, convertible loan agreement includes a loan which is a kind of pressure on the startups. Therefore, it is been claimed that convertible loan agreement is not one of the startup friendly investment means. On the other hand, Convertible Equity Agreement removes this pressure by not including any loan, interest, maturity date and etc. in it.
Convertible Equity Agreement has some popular versions called Simple Agreement for Future Equity (the SAFE) and Keep It Simple Security (the KISS). The SAFE was offered at the first time by ‘Y Combinator’ which is one of the accelerators in Silicon Valley. The SAFE does not include any debt, maturity date, interest etc. which could cause a risk for the startup or entrepreneur. Once an investor fund to a startup through the SAFE, the investor will have right to obtain equity at the next financing round. However, most of the investors think that the SAFE has not enough protection for an investor and it is absolutely in favor of the startups. Subsequent to this opinion, another accelerator introduced another form of Convertible Equity, which is called the KISS. The KISS is similar to Convertible Loan in some ways so is balancing the interests of investors and the startups. In this form of Convertible Equity includes debt, maturity date and interest like Convertible Loan but the KISS is replacing the right to request repayment at the maturity date with right to request conversion of the money into equites. Therefore, both investors and startups would be under the protection under the KISS.
In a nutshell, the convertible loans and convertible equity are the most traditional legal instruments used by the startups for raising money. As we told in this paper, there are cons and pros of both Convertible Loans and Convertible Equity, so the startups must carefully review these agreements to avoid the negative consequences.