Convertible Loans: An Attractive Financing Option for Founders

When starting a new venture, most founders rely on external capital, especially during the early stages like pre-seed and seed—essentially right after the company's inception.

Traditional loans often aren't viable for raising capital due to a lack of collateral, low creditworthiness, and high risk of default. Consequently, many founders turn to venture capital investors for start-up financing. In the earliest stages, these investors frequently provide funding through convertible loans.

What Is a Convertible Loan?

A convertible loan is a financing instrument that sits between a standard loan agreement and equity financing.

Venture capital investors supply funds by granting a loan. Unlike a traditional loan, the expectation isn't that the loan will be repaid in cash. Instead, the loan amount will convert into shares of the company—hence the term "convertible loan." The conversion typically occurs during the next financing round but can also happen at the loan's maturity date or during an early exit.

When the invested capital converts into shares, investors are usually granted a discount of 5–20% on the share price in the associated financing round. This discount rewards convertible lenders for investing before the financing round.

Advantages and Disadvantages for Founders and Investors

A major advantage of convertible loans is that the agreement between lender and borrower is relatively straightforward compared to traditional financing documentation. This simplicity allows for quicker signing and lower transaction costs.

Additionally, the often challenging task of valuing the company—which founders and investors usually negotiate jointly—can be postponed until the next financing round.

However, investors should be aware that convertible loans are typically unsecured and subordinated. If the start-up becomes insolvent, the lender has no security and ranks behind all other creditors—in effect, they are last in line. In this respect, a convertible loan is similar to equity.

Key Terms for Negotiation

When negotiating a convertible loan, founders and investors should discuss the following terms:

• Term of the Convertible Loan
• Interest Rate (typically between 0.1% and 8%)
• Discount on Financing Round and Exit
• Valuation Cap
• Conversion Events
• Guarantees (in some cases)
• Information Rights

How GAIA Can Assist with Convertible Loans

As a GAIA user, you have access to a standard convertible loan template that you can utilize. If you prefer, you can consult with a lawyer from our partner law firms to obtain a customized template or legal advice regarding your convertible loan. Additionally, GAIA helps you maintain an overview of all current convertible loans.

The most important contract terms—such as maturity date, interest rate, discount, and minimum valuation—are clearly displayed, so you always have the key terms at a glance. When it's time for the next financing round, you can use our financing simulation to model your new cap table, including the conversion of the convertible loans.

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Ready get start with your first convertible loan agreement now?