CONVERTIBLE LOANS – DISCOUNT AND CAP EXPLAINED

 In finance

INTRODUCTION

In need of cash? Investors are interested, but you hesitate about the present valuation of your company? Or you wish to avoid lengthy negotiations regarding the conditions of investment? Convertible debt is the solution!

A convertible loan is an interest bearing debt that (voluntarily or mandatorily) converts into share capital (equity) if certain conditions are met. A convertible loan allows your company to raise funding quickly and less expensively than equity. More importantly, it takes away the immediate need to agree on a valuation because you and your investor agree to use a valuation in the future. Often the value used in the next equity financing round.

DISCOUNT AND VALUATION CAP

Of course you will have to give the investor (the Early Investor) something in return for the risk he took to invest in your company at such an early stage and to protect him from being confronted with a future valuation that does not meet his expectations. Therefore, a convertible loan often has two key characteristics: (i) the discount and (ii) the valuation cap.

The discount is simply a discount on the price paid per share by the equity investor (the Equity Investor) in the next equity financing round, e.g. 20%.

A discount may be attractive for the Early Investor, but the price may still be higher than what he would have paid if he had purchased shares in your company immediately. For that reason, most investors will negotiate to also set a valuation cap on the price they will pay in the next round. The valuation cap (e.g. EUR 2,000,000) is the maximum valuation of the company the Early Investor is willing to accept upon conversion.

Because one method will usually give the Early Investor a higher rate of return than the other, convertible debt terms often provide that the Early Investor has the option to choose between the two.

 

HOW DOES IT WORK

Discount

If the agreed market value per share in the next equity financing round is EUR 300 (e.g. a valuation of EUR 3,000,000 divided by 10,000 outstanding shares) and the discount is 20%, the Early Investor will pay EUR 240 per share.

Let’s assume that the Early Investor has lent EUR 100,000 to your company. The number of shares he will receive is:

EUR 100.000 / EUR 240 = 417 shares

 Cap

If, in addition to the discount, also a valuation cap of EUR 2,000,000 applies, the Early Investor would in advance know that he would never pay more than EUR 200 per share.

By using the valuation cap the number of shares the Early Investor will receive is: 

EUR 100.000 / EUR 200 = 500 shares

A quick calculation learns that in this example a valuation of EUR 2,500,000 is the turning point, because: EUR 2,000,000 (cap) / 0,8 (discount) = EUR 2,500,000. In this example, the Early investor will choose for the cap.

FINALLY

Convertible loans are practical and easy. Get familiar with the features before you negotiate a discount and/or a cap.

To get an even better understanding, go to https://equity.gust.com/convertible-notes and try the convertible note calculator.

Of course we are also happy and ready to assist you: just get in touch!

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