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Startup funding: term loans, convertible loans and equity funding

Investor engagement

Investor engagement

Startup funding: term loans, convertible loans and equity funding

Lisa le Feber & Wout Bobbink, 6 August 2019

For a startup different sources of funding are available. This blog will provide a deep-dive into the term loan, the convertible loan and equity funding. The advantages and disadvantages of each financing method are set out for both startups as well as investors. Interested in other sources of startup funding? Then check out our article describing 12 sources of finance for entrepreneurs!

Before we go into the details, let’s first do a quick introduction on the three types of startup funding covered in this blog: term loans, convertible loans and equity funding.

Term loans are commonly used to fund businesses and are mostly granted by banks. The lender requires a concrete business plan and often collateral or a personal guarantee from the founders. Some governmental programs or private funds provide special startup loans to start or grow your own business. Loans are granted for short or long term against market interest rates and have to be repaid either at a specific date, in terms, or a combination of both.

Most convertible loans allow companies to raise funding without providing any collateral or guarantees. The investor that provides a convertible loan will have the right to convert the loan into equity stake (shares) in the company at a certain point in time or at the occurrence of certain events.

Finally, if an investor invests in equity, the investor receives shares, a stake in the company, in exchange for his investment. Angel investors and Venture Capitalists (VCs) typically use equity funding.

Below you can find an overview of the three types of startup funding, including advantages and disadvantages for both the startup and the investor. For a more in-depth explanation of these funding types you can scroll down the overview and read more information.

Do you want to learn more about these three types of funding? Then please contact Lisa le Feber or the EY Finance Navigator team.

Term Loan

Convertible Loan

Equity

Summary

A term loan can be granted for short or long-term against market interest rates and has to be repaid at a specific date or in terms, or a combination.

Summary

A convertible loan is a short or middle-term loan that can be converted into equity (shares). Typically the investor has the option to convert at the next investment round or after a certain time period.

Summary

(Direct) funding via equity, share capital, partnership interests or certificates.

Advantages

For start-up:

  • Does not give up any ownership of the business, no influence of the lender (via voting rights / general meeting)
  • Less (complex) documentation than convertible loan alternative

For lenders:

  • Higher interest rate than convertible loan alternative
  • Interest return regardless if profits will be made
  • Less risks than other two alternatives
  • Total loan amount repaid at the end of the term (independent on any profits being made)
  • Strict repayment scheme

Advantages

For start-up:

  • No high valuation of the company required at moment of financing
  • Prior to conversion no direct dilution
  • In principal no influence of the investor*
  • Investor's knowledge about the market
  • No collateral or personal liability*
  • Typically lower interest rates than term loan alternative

For investors:

  • Conversion right
  • Receives interest prior to conversion
  • Less risk than providing equity contribution from the start
  • Discount on the shares at moment of conversion*
  • Interest will accrue before conversion regardless of any profity being made

Advantages

For start-up:

  • Flexibility
  • No collateral required
  • No repayment terms
  • Conditions can be tailored to the needs of the business
  • Investors with specific knowledge can be attracted
  • Investors participate with personal stake in the success of the company
  • No collateral or personal liability/guarantee required

For investors:

  • Profit-sharing, (potentially) high rate of return
  • Flexible: different types of shares (voting / non-voting), preference shares or other rights (e.g. approval/appointment of directors)*
  • Possibility to exercise voting rights
  • Influence on the strategy of the company
  • Increasing value of investment

Disadvantages

For start-up:

  • Less flexible negotiation position
  • Requires collateral or a guarantee (personal liability)*
  • Higher interest rates, interest will accrue regardless of any profit being made
  • Strict repayment scheme
  • Qualifies as short or long term debt that may affect the financial ratios

For lenders:

  • No upside potential
  • No influence via voting/meeting rights

Disadvantages

For start-up:

  • No control over the right of conversion*
  • Dilution for the founders occurs at conversion
  • After conversion profit-sharing and new shareholders If not converted, refinancing or repayment must occur at maturity date
  • More (complex) documentation

For investors:

  • No/limited upside potential before conversion
  • No influence via voting/meeting rights* until conversion

Disadvantages

For start-up:

  • Interest of the investors (shareholders) will have to be taken into account
  • Dilution for the founders
  • Profit-sharing*
  • Disagreements between shareholders can disrupt business (this can be covered by a shareholders agreement)*

For investors:

  • Higher risk, subordinated to all creditors of the company
  • Chances of getting a repayment in case of bankruptcy are very low

[1] All items marked with a * are commercial items of negotiation.

[2] Overall note: Classification of a liability as a long or short term payable (and for an asset as fixed or current asset) may impact on how users may perceive the financial statements/balance sheet and therewith their opinion on e.g. the financial position of a company. Presenting an asset line-item as fixed assets (e.g. long term loan receivables) or as current asset (e.g. intercompany current account receivable) or a liability line-item as long term debt (e.g. loans payable) or as current liability (e.g. intercompany current account payable) do have impact on working capital ratio/quick ratio.

Three sources of startup funding: term loans, convertible loans and equity funding.

1. Startup funding using a term loan

As described above a term loan is usually provided by a bank. It is granted for a short or (medium) long term against market interest rates and has to be repaid either at a specific date, in terms, or a combination of both.

Advantages for startups

The main advantage of a term loan for startups is that the lender does not become a shareholder of the startup and as such will not have voting rights in the general meeting of the startup. The lender will have no influence over the normal day-to-day business of the startup.

Furthermore, depending on the size and terms of the loan, less (complex) documentation is needed compared to a convertible loan structure. That means less discussion between startup and lender, less effort and most likely also fewer costs in connection with the preparation of the required loan documentation.

Advantages for lenders

A term loan has several advantages for the lender as well. Typically, term loans have higher interest rates than convertible loans. The interest payments in combination with the fact a startup often has to provide collateral to ensure the loan can be repaid, makes this type of financing less risky for the lender compared to equity funding and (to a certain extent) a convertible loan.

Other advantages for the lender are the strict repayment scheme and the fact that the startup needs to repay the loan during the term or at the end of the term (independent of any profits being made). Collateral or guarantees serve as security in case the startup is not able to repay the loan from its normal cashflow.

Disadvantages for startups

Term loans are often a difficult funding mechanism for startups. Due to stricter post-crisis regulations financial institutions are nowadays more limited in how and what they finance.

This results in a less flexible negotiation position for the startup and in collateral/guarantee requirements imposed on the startup by the lender, as the risk of not getting repaid is normally higher in case of startup funding. The provision of personal guarantees by the founders is not uncommon, which in the worst case could mean that a founder’s personal assets (e.g. house) are seized to satisfy the loan if the startup is unable to repay it.

Some other disadvantages of term loans for startups are the normally higher interest rates (compared to convertible loans) and the fact that interest is not linked to company profit: the loan needs to be repaid regardless of the financial performance of the startup. Moreover, a term loan usually comes with a strict repayment scheme.

Disadvantages for lenders

The main disadvantage of using term loans for startup funding is the lack of upside potential for the lender. The benefits of for example equity funding increase with the growth and performance of the startup, as the investor owns a stake in the company. The better the startup performs (financially), the higher in principle the dividend payments for shareholders and the higher the chances the startup will be acquired (which could result in a lucrative exit deal for the shareholders).

This does not apply to term loans. The only financial benefit for the lender are the interest payments. No matter how good the startup performs, the financial benefit for the lender will not increase.

A second downside of term loans from the lender point of view is the limited amount of influence the lender has on the startup’s company strategy and its day-to-day business. Equity funding regularly comes with (some form of) control of the shareholder over the startup, for example a seat at the board of directors, which enables it to influence decision making for the startup.

2. Startup funding using a convertible loan

A convertible loan is a mixture between a term loan and equity funding. It is a short or middle-term loan  that can be converted into equity (shares). Typically the investor has the option to convert at the next investment round, after a certain time period or with the occurrence of certain events.

So as an example, if a startup raises a convertible loan as seed funding, the loan can be converted into equity when the startup raises funds for taking its business to the next level, for instance Series A funding.

Advantages for startups

The main advantage of a convertible loan for startups is that a valuation of the startup is postponed to a later moment. Startup valuation can be difficult since financials are often not yet available, or hard to substantiate. After all, the company is only just getting started and does not yet have a financial track record.

An equity deal requires a valuation since you need to define the value of the shares the investor will acquire. A convertible loan does not require a valuation (as it starts as a loan), which means it saves founders negotiations and documentation (and with that, time and money). Furthermore, there is no dilution for the existing shareholders/founders until the loan is converted.

Other advantages for the startup founders are typically the lack of influence of the investor over the company it is investing in (could be an item of negotiation, though), while on the other hand the startup can potentially benefit from the business network the investor has, including for example other investors or business developers.

Furthermore, in general the interest rates for convertible loans are lower than the rates for term loans resulting in a lower financial burden for the startup. Finally, in most cases a convertible loan does not require collateral or a personal guarantee from the startup and its founders. You could in fact see the option to convert into equity as the collateral that is being provided by the startup.

Advantages for investors

Convertible loans offer several benefits for investors as well. First of all, the investor will benefit from interest payments on the loan. In practice, in most cases the interest is accrued: when conversion takes place the accumulated interest is converted into equity (together with the loan). These interest payments are accrued regardless of any profits being made by the startup.

Secondly, the right to convert into equity is obviously an advantage in itself. It can potentially result in (large) financial upside for the investor depending on the performance of the startup, as it will become a shareholder upon conversion. Typically, the investor will receive a discount on the share price compared to external new investors.

The discount rate can be discussed when negotiating a convertible loan agreement. A final advantage for the investor is that a convertible loan poses less risk than an equity contribution. This is because the investor can require repayment of the loan at the loan’s maturity date (if not converted), which is not the case for a “normal” equity investor.

Disadvantages for startups

The last advantage for investors mentioned in the previous paragraph is one of the main disadvantages for the startup. If the loan is not converted upon maturity, the startup needs to repay the loan (including any accrued interest) to the investor.

If the startup’s cashflow is insufficient this could basically result in the end of the startup, unless it is able to refinance the loan and repay its debt. Moreover, the founders do not always have control over if and when conversion takes place, but can depend on the investor’s preferences or the conversion conditions as agreed in loan agreement.

Compared to a term loan another disadvantage is the fact that as of the moment a conversion takes place dilution starts playing a role, which can result in a decrease of the founders’ ownership percentage in the company and potentially impact dividend distributions.

Also more (complex) documentation is required for a convertible loan agreement compared to a term loan, which could make the process of entering into such an agreement more lengthy and costly.

Disadvantages for investors

For investors the downsides of a convertible loan structure are limited. Before conversion takes place there is no upside potential in terms of profit-sharing (or an exit) yet and, in most cases, the investor does not have the rights a preferential shareholder would have (e.g. a seat at the board, voting rights). The latter could be a commercial item of negotiation though when the convertible loan is set up and documented.

3. Startup funding using equity

If an investor invests in equity of a startup the investor receives shares (or partnership interests/certificates) in the company in return for its investment. This funding method is widely adopted by angel investors and VCs to invest in startups.

Advantages for startups

The main advantage of equity funding for startups compared to loans is that equity funding is a “cheaper” way of funding (at least in the short term). There is no (personal) collateral required, no repayment of the principal amount at a certain maturity date and there are no interest rate payments either.

Furthermore, since the terms of the equity deal can be tailored to the needs of the startup (in discussions/negotiations with the investor) equity funding can offer more flexibility of underlying conditions.

Moreover, since the upside potential for the investor is largely dependent on the success of the startup, investors often try to contribute to the success of the startup as well. They can bring in specific knowledge or a business network in the form of clients, suppliers or other investors for instance.

Especially angel/informal investors commonly participate with a personal stake in the success of the company and are often seasoned entrepreneurs themselves. This could turn out to be of great value to the startup founders.

Advantages for investors

The biggest (potential) benefit of equity funding for investors is the upside potential in terms of profit sharing as (co-)owner of the company. If a startup performs well, the investor receives a high rate of return on its investment (dividend).

This could mean that the financial result the investor obtains eventually exceeds the amount of its initial investment in the startup. Moreover, a highly successful startup's share value increase could benefit the investor as well, for instance when he wants to exit and the investor’s shares are sold to a new investor.

The fact that the conditions of an equity deal can be tailored to the needs of the startup is not only an advantage for the startup, it is also an advantage for an investor: flexibility in the underlying conditions can be leveraged by the investor to try and make sure its requirements are fulfilled (that is why the underlying conditions of a deal are always a negotiation between startup and investor).

Think for instance of the type of shares (voting vs. non-voting) the investor acquires, whether or not it will receive preference shares or whether it will have any other rights (such as approving or appointing directors). That way the investor may be able to influence the startup’s company strategy and by that contribute to its performance and, hopefully, increase shareholder value.

Disadvantages for startups

One of the bigger challenges of equity funding for startups is that the interest of all shareholders needs to be taken into account by the founders, including those of the investor as equity provider (how formal this interest is, is defined by the underlying conditions of the equity deal).

This could be an advantage as the investor will often try to support the founders as the startup’s success is in its own interest. However, disagreements or disputes between the shareholders (e.g. the founders and/or investors) can potentially disrupt the company. The relationship between shareholders, including in case of disputes, is usually addressed in a shareholders agreement.

Other disadvantages can be dilution in ownership percentage of the founders and profit sharing with the new shareholder.

Disadvantages for investors

The main disadvantage for the investor is that there is a substantial chance it might not earn a return on the investment or might not even get back the investment at all. Investing in startups implicates taking more risk. In case of liquidation the shareholders are the last in line to get their investment back. They are subordinated to all creditors of the company. In other words: the chances of getting a repayment in case of bankruptcy are low (if the company even has assets left to distribute at all).

Conclusion

Startup funding can be obtained in different ways and each type of funding has its own benefits and challenges for both startup founder as well as lender/investor. When in search of financing it is therefore crucial to take into account availability of financing, funding stage (e.g. pre-seed, seed, Series A, etc.) and the reason why funding is actually needed.

Based on among other things these parameters you can define which type of funding can be the best fit for your case. Interested in learning more about different sources of startup funding? Then check out our article describing 12 sources of finance for entrepreneurs!

Having a proper financial plan in place is a crucial element of practically any fundraising process, no matter the type of funding you go for. Want to learn more about financial modeling and make sure you come up with a professional financial plan when pitching to investors? Check out our ultimate guide to financial modeling for startups!


Need help building your startup’s financial model? Check out our financial planning software for startups. It’s fast, it’s easy and it’s built for you!