Convertible Loan Basics

Traditionally, when an early stage company was seeking quick financing, it often turned to convertible debt instruments, most commonly referred to as convertible loan agreements.
 
A convertible loan agreement  (“CLA”) is an agreement between a lender and a company whereby the lender loans the company a specific loan amount.  The lender can either get repaid cash upon the maturity date (usually with interest), or instead of repayment, convert the loan into company equity upon a qualified financing event. The qualified financing event (the “QF”) is often a new round of financing in which the company issues new shares to a third party investor. Under the terms of the convertible loan agreement, in a QF the lender often automatically converts into the same type of shares as the third party investor, but at a discounted price.
 
Benefits of a convertible loan agreement: 
   For the company - 

1. The company receives funding more quickly than it would, had the financing round been for equity.
2. At this stage, the Company need not enter negotiations for stock liquidation preferences, anti-dilution      protection, registration rights, etc., since the lender is not becoming a shareholder.
3. The Company, thus, avoids the long hours and expenses of the drafting of numerous transaction documents that usually accompany a share purchase agreement as opposed to the shorter and more concise CLA.

    For the lender –

1. The lender will receive future stock at a discounted price.
2. If the company will not reach the qualified financing event by the maturity date, the lender is entitled to receive repayment of his loan. The lender can even negotiate a higher return percentage, such as 150% or 200% of the loan amount. In some cases, lenders have negotiated up to 500% of the loan amount back.
   
3. Until the company either converts or repays the loan, the lender, essentially, remains a creditor. Debts owed to such creditors generally take priority over any shareholder debt.