Convertible debt as a temporary alternative to equity?

In current market environment raising equity capital for a startup has become significantly harder compared to just a few years ago. However, there are alternatives which founders ought to consider, and one such alternative is the use of debt financing, more specifically in the form of convertible loans. Such loan instrument also has certain benefits in a market where current valuations and below previous rounds. Learn more from the blog article by our partner TGS Baltic.

This article was written by Mirko Kikkamägi, Senior Associate at TGS Baltic.

For the majority of European startup founders considering capital raising 2022 was a year to forget. What began with a booming venture capital market, record valuations and zero-interest environment, which coincided with the top US stock index’s all-time high in January, soon first felt the chilling effect of the stock market downturn followed by the unimaginable – Russia’s unprovoked invasion of Ukraine and war. The latter triggered uncertainty and crisis in all possible spheres of life – people lost the sense of security, commodity prices spiked, inflation rocketed and investments in countries neighboring Russia temporarily all but halted or dried up. As that was not enough, interest rate hikes by the US Federal Reserve Board, starting in March 2022 and continuing throughout the year all but raised the price of capital on both sides of the Atlantic and dried up the abundant pools of cash which were so recently available for any startup able to formulate a decent pitch.

As the shock of 2022 passed and capital markets seemed to come to grips with a changed world, 2023 brought solace that we are seemingly getting back to a friendlier environment for startups. However, we were reminded of the fragility of the current environment by the failure of Silicon Valley Bank, which over the second weekend in March, put in jeopardy the financial health of startups and tech companies otherwise in healthy conditions.

All quiet on the investment front

Therefore, it is not surprising that in the current environment, investors are more cautious in making investments. This, of course, does not mean that good startups worthy of financing won’t be able to access funding (as 2022 also showed that quality investment targets were able to raise significant amounts of capital despite the challenging outlook); rather, on average, obtaining investments is harder, and more often than not they are made based on lower valuations than founders would have hoped considering what we have seen over the past few years.

Thus, a startup founder in need of capital is faced with a dilemma – to target equity investment at a lower valuation or seek alternatives. One possible route could be a more extensive use of debt capital, either as a means itself or as a bridge financing to future equity financing, hopefully to take place in a more favorable environment.

Back to basic…no, debt / Debt as alternative to dried-up equity investments

While some later-stage startups with a proven business model and positive or close to positive cash flow might be able to access traditional bank financing, or in some cases, even funding provided by supranational lenders like European Investment Bank or similar institutions, the majority of startups do not have the required collateral or cashflow to support traditional debt financing. In such cases, convertible loans are the only real alternatives. 

While convertible loans are part of normal startup financing even during the so-called good times, they may be extremely tempting option during such uncertain times where, despite the existence of large pools of VC “dry powder”, such capital is not being put to use. Whether this is due to the judgment calls of the people in charge of allocating such capital (mainly the general partners of VC funds) or due to the providers of actual capital (usually limited partners in VC funds) being reluctant to approve such allocation of capital and/or related draw downs (in practice VC funds do not hold their free investable cash in their account, rather they have arrangements with providers of capital – the limited partners – that upon suitable investment, the limited partners make available their proportion of the investment), the practical effect on startups is that equity financings are harder to pull-off and in some cases can even results in investment rounds at a lower price per share than previous rounds, so-called down rounds.

The sad realities of down round

From founders’ point of view, down round is one of the worst things that can happen. Due to standard anti-dilution protection regulations found in almost all investment transaction documents, upon occurrence of a down round, it is usually the founders whose ownership is unproportionally to other shareholders “wiped out”. This is because, in simplified terms, anti-dilution protection regulation works in a way that when the price of new shares issued in an equity round is lower than the price per share in the previous round, the previous round investors are compensated for the decrease in the value of their shares by being issued additional shares. Overall, this increases the number of shares while keeping the number of shares owned by the founders the same and thus reducing their ownership percentage and subsequently resulting in diluting their shareholding.

Convertible loans – magic wands?

Therefore, the ability to raise funds now without issuing actual shares might be a tempting option for trying to ride through the stormy waters. However, this assumes that the existing investors do not have the veto right to block the issuance of convertible loans (as, in some cases, down round might be preferable from their point of view). That said, when the founders do have the necessary votes and control to issue convertible loans, it is vital that they get the economic terms right. Standard characteristic of a convertible loan is that it carries interest, meaning upon conversion not only the loan amount, but the loan amount together with the accrued interest will be converted into equity. Thus, getting the right balance between the interest rate and the term of the loan is a tricky matter, but if one manages to do that, the use of a convertible loan may provide both the much-needed financing and the delay in the actual equity round which determines the current valuation of the company. However, one needs to keep in mind the risk that if, upon expiry of the loan term, the company is not best placed to do a financing round, the loans may still be converted into the equity of the startup at a serious discount and with the effect, which from the founder’s point of view does not differ much from a down round one aimed to avoid altogether. In such case, no 10 points to Gryffindor after all.

Mirko Kikkamägi and Sander Kärson from law firm TGS Baltic together with founders Kaspar Korjus from Pactum AI and Marek Pärtel from EstateGuru will give a seminar titled “What to bear in mind when fundraising and negotiating transaction documents – practical view from founders and lawyers” on Day 1 of sTARTUp Day on 16 March. Check out the full seminar schedule here.

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