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Rockstart Law School: Convertible Loans – Discount and Cap Explained

Setting up and running a startup requires knowledge of the industry that you are in. It also requires knowledge about finance, marketing, customer service, management, and legal matters. There is no way of knowing everything you need to know, which is why the network that supports you becomes a valuable tool and asset.

Rockstart Law School is a combination of blog posts by outside contributors and vlog posts by Rockstart’s very own legal counsels Els Metten and Lisette Schuilwerve. They will show the roadmap to the legal side of starting and running a startup company. Rockstart Law School focuses on the Dutch law system and is meant as a resource and gives you lessons learned and suggestions, but is not meant to be used in the place of legal advice. Always consult your lawyer, but we hope this series of posts will give you a greater understanding of the legal needs and points of attention that you may encounter during your startup journey.

In need of cash? Investors are interested, but you hesitate about the present valuation of your company? Or you wish to avoid (sometimes lengthy) negotiations regarding the terms of investment, especially shareholding terms (such as the type of shares, consent rights, good leaver/bad leaver constructions, drag along and tag along, anti-dilution)? Convertible debt might be the solution, but pay good attention—especially to the discount and cap.

A convertible loan is an interest (at this moment usually around 6 percent) bearing debt that converts into share capital (equity) if certain conditions are met. A convertible loan allows your company to raise funding usually more quickly and less expensively than equity. It also takes away the immediate need to agree on a present 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

The investor (the Early Investor) will want something in return for the risk taken to invest in your company at 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 in the next equity financing round (the Equity Investor), e.g. 20 percent (usually, the discount varies between 15 and 25 percent, but we also see lower and higher discounts).

A discount may be attractive for the Early Investor, but the price may still be higher than what they would have paid if they 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. €2,000,000) is the maximum valuation of the company the Early Investor is willing to accept upon conversion. Please note: the higher the cap, the lower the dilution of the founders.

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. But don’t give yourself away too easily!

How does it work?

Discount

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

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

€100.000 / €240 = 417 shares

Cap

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

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

€100.000 / €200 = 500 shares

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

Please note that calculation methods may vary. Always carefully check the exact wording.

Finally

Convertible loans can be 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 Convertible Note Calculator and try it out.

Also read: How much Equity is a Convertible Note Worth?

A few tips:

  • Set your valuation cap (if any) as high as possible. Keep in mind that the valuation cap should reflect a future valuation and not your present valuation
  • Of course, set your discount percent as low as possible
  • Try to negotiate that the Early Investor is granted common shares at conversion (instead of the same type of shares as the Equity Investor)
  • Include that the loan will mandatorily convert at the next equity round, in order to avoid any negotiation power for the Early Investor at such round
  • Don’t co-sign in private for repayment of the loan

Niels Kloppenburg & Richard Goemans are partners at Venture Lawyers, an Amsterdam-based entrepreneurial law firm, specialized in corporate transactions with a focus on venture capital and M&A. With over thirty years of combined experience at renowned law firms, they know the way. They understand your business, provide day-to-day guidance and assist with strategic decisions to get you where you want to be. To get the job done, Venture Lawyers work in partnership with their clients. And with the highest quality advisors specializing in related fields to provide a full scope of services tailored to your needs. Get in touch with them here.


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