Convertible loan & equity financing

Hi there!

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Summer is in full swing, but the business world is still abuzz. As usual, we’re here to help you understand basic legal terms for startups so you’re always one step ahead. Today, we’re looking at another piece of the investment puzzle: deciding between convertible loans and equity financing.

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What's a convertible loan and equity financing?

When you’re raising funds as a European startupist, you’ll most likely be deciding between a convertible loan and equity as a form of financing.

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A convertible loan is a loan that either converts into equity or gets repaid at a future date. It gives startups quick access to cash without transferring company ownership (yet). Convertible loans are ideal for early-stage startups and startups that are unsure about their valuation.

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In an equity financing, investors become the company’s shareholders with all the connected shareholders’ rights. Equity investment is ideal for startups that are raising more significant funds, have more potential investors and more time & resources to set up governance with new stakeholders.

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Why does this matter?

The choice between a convertible loan and equity has a huge impact on the company’s cap table, founder-investor negotiations and investor rights.

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Here’s our pick of the top 3 differences:

1. Convertible loans don’t have immediate impact on cap table. Equity financing does.
2. Investors in equity rounds will try to negotiate their position in the company in full. Convertible loan investors will typically postpone these discussions.
3. Convertible loan investors will try to protect their rights in the upcoming equity round. Equity investors will try to secure their rights in all future rounds.

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Pros and cons

Each type of financing has its pros and cons. Here's our rundown.

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Convertible loan

Pros

• can be done in a couple of days
• valuation isn’t needed
• investors don’t enter cap table (yet)

Cons

• might create wrong incentives for unreasonable investors
• cap table can get messy with multiple CL rounds
• risk of repayment (in cash)

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Equity financing

Pros

• easier to find equity investors
• no repayment obligation
• lower risk financing option

Cons

• dilutes existing shareholders
• valuation is a must
• takes weeks to months

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That's all for today! If you need assistance with your term sheet or have any questions, don't hesitate to reach out to us. Follow us on LinkedIn to stay tuned for our next newsletter!