Early-Stage Finanzierungen mithilfe von Convertible Loans [ENG] | #Investoren 💰

00:00:00: Hello and a warm welcome to another Insight VC podcast from Digital Compact.

00:00:03: My name is Joe Katzmarek, and next to me is Christian.

00:00:05: Hey Christian!

00:00:06: Hey Israel.

00:00:07: hi

00:00:08: This time we're about to talk about convertibles, convertible loans starting off like right with the definition.

00:00:14: What does it say?

00:00:14: convertible for founder that has never heard of?

00:00:16: The way I would frame It Is you basically get alone into the company But You Would Likely Normally Expect That You Have To Pay Back Alone Over Time.

00:00:26: Hear The Difference And Hence The Term Convertible.

00:00:29: The expectation is that at some point and at some price, the loan gets converted into equity.

00:00:35: So you're basically using a loan to put money in the company quickly with the expectation that ultimately it will be part of an equity transaction.

00:00:49: Before we speak about the terms and how it is done, the mechanics.

00:00:52: Let's say what are these situations where you use this?

00:00:55: Because I had the impression that especially business angels in Berlin started to think about convertible loans because there was a nice instrument of getting started quite fast... ...and having the possibility asking for your money back or investing really directly.

00:01:07: when do you use a convertible normally?

00:01:09: What situation would be used

00:01:10: by them?

00:01:11: Yeah so they're couple different situations.

00:01:13: The first one already alluded too which In the seed stage it is often done.

00:01:18: because really of two reasons.

00:01:20: One, It's very simple to document.

00:01:23: you only need a couple pages of documents and its easy to implement.

00:01:27: You can close on rolling basis so I have an open convertible note And i'm just adding people.

00:01:35: as I close them they can wire their money.

00:01:39: I accumulate a certain amount of money up to maximum that typically set in the beginning and can do on rolling basis which is hard with equity.

00:01:48: The other big reason why it's very often used, you don't have any investors' setup price for your business an attached valuation because this is very often hard at the begining.

00:02:02: some people may raise their money from may not be use to putting evaluation on those businesses.

00:02:09: And so in the absence of a strong lead that does that, it is sometimes just easier to say hey you know we start with this note and then once somebody does put a price on the business and leads an equity round it gets converted and we can talk about how those mechanic works.

00:02:23: That's really one situation where you often see convertibles being used.

00:02:29: The other situations are what is also referred as bridge or bridge-note have a company that's already raised the financing round, and for whatever reason doesn't want to go out and raise the next round before money runs out.

00:02:47: And so one way to bridge this financing gap is put in a convertible loan.

00:02:53: give the company additional runway time Before it goes out and raises another equity around.

00:03:00: then that money gets converted in the next equity round and has effectively served as an intermediate financing for that period between money running out from previous rounds, then new money coming into it.

00:03:17: So we had these two situations where you say convertible and as I said the advantages are basically helpful to speed It's easy to implement.

00:03:25: if not want a pricing this is a helpful tool.

00:03:28: What do consider disadvantages of a convertible note?

00:03:31: Disadvantages are that ultimately you have a loan sitting in the business.

00:03:37: So from the founder's perspective, That gives very strong leverage to investors when no equity round is inside because they can technically ask for their money back which typically cannot payback Because most of these businesses don't have positive cash flows really literally pay back the loan.

00:04:03: So where you have to be careful is if things don't go as planned and let's say, You know a period of one year on the loan or something like that?

00:04:12: And then it becomes due... ...you may end up in a situation.

00:04:16: That-that's a little ugly because.. ..you haven't had anyone to price around and either you have some kind of typically low default conversion price apply Or you can have very unpleasant conversation.

00:04:31: You know, hey we're obviously not in a situation to pay you back.

00:04:35: so We have to figure out evaluation at which we convert and with the absence of an outside third party Putting that price on the business.

00:04:44: That's just not A good conversation to half.

00:04:46: So I think that's one thing you really want to be very careful about.

00:04:52: And i think The other disadvantage is that it's not everyone likes because some people just want to have clarity about the price that they go in.

00:05:00: So, you know... They may not consider a convertible and just wanna do it priced round.

00:05:05: so That's clearly the other scenario.

00:05:09: And as for seed I think with the bridge around The tricky part is little bit more.

00:05:15: You wanna have very good explanation As why your doing a bridge?

00:05:19: Why actually its not result of you're not having been able to attract additional funding, and therefore sending a negative message.

00:05:28: Which then sometimes is reflected in some of the terms... ...in The Bridge so that we want to be careful about having the right optics there.

00:05:38: You just wanna explain very well why your using A Bridge And still have business that's fundamentally attractive for people who invest in.

00:05:48: Young founder may ask now if my company becomes a fuck-up, like... If it's really not working and I'm closing or shutting down.

00:05:56: in convertible loans there is the word loan.

00:05:58: And usually when you go to a bank and ask for a loan You need to pay back afterwards.

00:06:01: In difference with venture capital which we do not have because as said this is a venture capital.

00:06:07: How about convertibles?

00:06:08: Do i have to pay them back if they are fucked up?

00:06:11: No so that's good news.

00:06:13: The loans were given by the company.

00:06:17: So at least in my experience, I've never seen personal liability.

00:06:21: While banks sometimes ask you to give personal guarantees against a loan that you take out for business as your own... ...I have not ever seen this done in venture and honestly would not consider it fair And we'd asked them if they were waived.

00:06:37: when investing into the company where something like was in place The loan is given by the company If the company becomes insolvent.

00:06:46: You know, you have the typical hierarchy and typically actually this type of loan is something where you immediately give other debtors precedent.

00:06:57: So in Germany it's called a Rangrücktritt.

00:06:59: so... ...you put that loan from structural perspective behind other claims.. ..so then company not automatically insolvent because otherwise could create situation when we put money into their company as soon as its getting started To get used up by operational burn.

00:07:16: the company is technically insolvent so you want to have just a special term for that in there?

00:07:21: To accommodate that and beyond That?

00:07:24: no it's tied to the fate of the company.

00:07:26: if the company as well It's okay, and if not.

00:07:28: You know its loss

00:07:30: now.

00:07:30: then let's deep dive into the mechanics of convertible nodes.

00:07:35: I think a founder can hardly imagine that an investor will give you money, and then waits for the crystal ball or in front of his crystal ball to ask for pricing afterwards.

00:07:43: How does it work?

00:07:44: That's really key because one thing we've got to remember is venture capital is fundamentally equity instrument.

00:07:51: You take risk pay price for shares And fully participate in upside because you're aligned with founders.

00:07:58: debt on opposite side Is tool where traditionally only give money to people where you expect them To actually pay it back didn't work so well in the housing bus But typically that's what debt is, you know meant for on the flip side.

00:08:13: You don't participate in the upside if you have given debt to someone who became extremely successful or Became a mediocre company but stayed alive.

00:08:21: You're not gonna make more less money Where on the equity?

00:08:24: It's its exact opposite right.

00:08:26: So your bridging sort of two very different financial instruments and there are really two key terms that allow people who really want to be on the equity side of, you know... ...the river.

00:08:38: To start on the debt-side and those are basically dictating how the conversion.. ..how crossing off a river happens.

00:08:45: And what do we need is someone come in within defined period time.

00:08:50: What then define as qualified financing?

00:08:53: So there's usually an equity financing round of minimum volume.

00:08:58: It can be one million two million five million whatever stage the company is at and an independent third party puts in, you know that money At a certain price.

00:09:07: And then you convert your loan Into equity at the same terms as that independent party with usually A discount.

00:09:18: so That discount can be twenty percent twenty five percent thirty percent Maybe ten percent.

00:09:23: it really depends on how long that loan has been sitting In The Company.

00:09:28: because effectively what has Been Happening Is The company has been using your money that you put in with a loan for building enterprise value, for developing the business.

00:09:38: For growth.

00:09:39: now That growth is what?

00:09:42: New investor pays a higher price for then You really should have paid as the one who gave the loan three months back six month back nine-months Back.

00:09:50: so if you give it alone Three Month ago maybe The growth in enterprise value isn't that dramatic, and a smaller discount is appropriate.

00:09:58: If you gave the loan nine months ago... ...and started with a guy on PowerPoint now there's a product,... You should probably have significant discounts.

00:10:07: So the discount rate depends typically on time it has passed since the loan was given.

00:10:14: And sometimes investors also ask for what's called a cap.

00:10:19: so.... Let's say you have a ten million conversion cap.

00:10:24: What it means is if somebody steps in and says, I'm going to invest at the twenty million pre And we'll have a discount rate of twenty percent You should really convert your shares theoretically At a price of sixty million right?

00:10:37: so sixteen million enterprise value Twenty million minus twenty percent.

00:10:41: now If you don't think that's fair because you're really helped start with The company whatever price the outsider says, minus twenty percent but in no event more than let's say ten million pre-money if that is or valuation.

00:10:57: If it was a cap you have put into place so we can make sure either somebody crazy comes around who pays a price that you think is just completely inappropriate Or your convertible will sit there for building substantial enterprise value compared to when you put it then its appropriate.

00:11:18: I

00:11:20: think it's probably also possible to combine these two, right?

00:11:23: Yes.

00:11:23: Yeah so that's routinely done.

00:11:26: So you typically say i have a discount but the cap is at x. You basically In situations where somebody comes in and a price that's over then your cap... ...you just apply the discount rate And there one point as evaluation sort of goes up The discount crosses the level of the cap Then kind of stands still there.

00:11:47: That why its called a cap right?

00:11:48: So then you would never under any standard pay more or convert at a price that's higher than the cap price.

00:11:55: What about interests, I mean loans usually come with interest.

00:11:58: yeah i mean not so much these days anymore but on high-risk loans absolutely and yes there is some interest.

00:12:07: very often even if an investor wants to give it without interest they cannot because there are certain regulatory rules as to a minimum interest that you have to charge, given just the way let's say the asset class is structured.

00:12:20: And so however what we typically do is this interest doesn't get paid it gets accrued So basically added to loan amount and then when its time to convert You convert the interests alongside The principal amount that has been paid in.

00:12:37: What does typically here?

00:12:38: So typically it gets converted or you mean It varies quite a lot.

00:12:43: I would say it varies probably between five and fifteen percent.

00:12:47: so the range is pretty big.

00:12:49: Yeah, that's rather attractive in comparison to Invest into housing.

00:12:53: yeah absolutely.

00:12:54: on the other hand side i mean To be honest it really doesn't move The needle So much because you only have it sitting In there for a few months.

00:13:01: typically And also?

00:13:04: I mean its all about the risk profile and evaluation.

00:13:06: You know if the deal ultimately gets done at ten pre or twenty pre That's what makes a huge difference.

00:13:12: if you got, you know five six percent of interest per month that's A nice add-on.

00:13:16: but you're taking the fundamental risk If there is gonna be financing around and that's really You know The big watershed moment.

00:13:24: If it that really comes around

00:13:25: yeah absolutely make sense.

00:13:26: What does the time frame of a convertible by the way like typically?

00:13:29: how long?

00:13:29: Does he Yeah, they money stay in the company before this turned or the concept has turn into equity.

00:13:35: Yes So I think in seed situations It can be up to let's say a year.

00:13:40: It really depends, but it can be relatively long because you don't have high burn in the beginning and you want to create an milestone that allows somebody to price their equity or raise a series A. If it is more of bridge-type financing where you wanna cover the gap between two financing rounds You're typically looking at three to six months off runway.

00:14:01: What happens if there are changes of controls?

00:14:04: That's very interesting point.

00:14:05: One thing we need to make sure as investor.

00:14:08: I sometimes see that people don't actually think of that here in Germany, it's a standard term the US.

00:14:14: You want to be sure if the company gets sold then the buyer or the company doesn't just pay you back for money.

00:14:22: so assume your finance a seed deal and has very well as nice exit.

00:14:27: Then have some kind conversion prior to an exit.

00:14:33: So we call no pre-pay or a, you know conversion at the option of the loan holder.

00:14:42: that basically just allows You add a price.

00:14:44: That you determine When you?

00:14:48: Either sign the loan document Or at least your put in a mechanism So again with a discount or something like that for determining a price to convert Your loan into equity so that you can then really benefit from The exit as if we had made an equity investment because Again remember The low-instructure is really only a tool to do something quickly and efficiently.

00:15:10: that's meant ultimately as an equity instrument.

00:15:13: Are there also situations where it becomes possible that a founder says, hey I would like to do a prepay in general because they're so much interest from American VCs or in general from VCs.I'm really overwhelmed by this and i think your value you created isn't big enough for the valuation cap we spoke about isnt fair?

00:15:31: I'd like pay back your money.

00:15:32: Yeah!

00:15:32: So payback as opposed having you convert into the round.

00:15:35: Yes That can happen.

00:15:37: And then You've had bad lawyer As an investor Because you want make sure doesn't happens If you are taking risk of financing the company through a period where there is no other capital available for whatever reason.

00:15:47: You want to be able that if things turn out well, then you can convert into equity and you can ride the upside as opposed to get your money back plus a couple percent of interest.

00:15:57: so you clearly wanna have right-to-convert at such an qualified financing event... depending on how it's negotiated not HAVE TO CONVERT!

00:16:06: If let say the bridge is small compared with the ultimate raise For whatever reason, you may want to ask for your money back assuming that.

00:16:13: You know?

00:16:14: For example, you're already very happy with the ownership you have in the company um...you've already put it a lot of capital Whatever The Reason Maybe.

00:16:20: so you might wanna retain That Optionality Of Being able To Ask for It Back If The Situation Allows.

00:16:28: But He Clearly Wanted Be Sure That You Cannot be shut out from converting.

00:16:32: Now there's another adept instrument some founders may have heard of which is called Debt Financing, I think we should have a note here or small sentence about this as well because convertible loans do not have to anything with debt financing in the classical way... Some big players doing later stage.

00:16:46: maybe one sentence about that.

00:16:48: Debt financing or venture debt typically call it last sort of financial instrument once you stay on the dead side so-to speak.

00:16:58: It really kind of is a bit of hybrid between what the bank would do and what VCs will do in the sense that it's structured more similar to a classical loan you'd get from a bank with monthly payback.

00:17:11: And, y'know... The ultimate goal just getting money back plus interest as opposed to converting into equity right?

00:17:19: Why I say this also has elements over VC because sometimes there are some parts debt deal where they ask for a little bit of equity as a kicker, or there are other mechanisms that you typically wouldn't see in a bank loan.

00:17:35: But venture-debt basically covers the gap between VCs where they give you money for the equity upside and obviously have to suffer dilution as a founder from that.

00:17:47: but you get money in situations when it just cannot prove that you will be able to pay back right?

00:17:53: That's the whole business model of VC.

00:17:55: The Bank on Flipside is never going to give you money unless you can really prove them that your gonna pay it back.

00:18:01: or maybe tell the okay, take my house as a guarantee which I said before we don't want do.

00:18:06: So if your business mature enough for then venture debt potentially the right choice because they have some terms.

00:18:15: allow them alone at time when there's past profitability.

00:18:21: but far from having numbers local bank would ask.

00:18:25: I think it makes sense to speak about this, because maybe confusing for especially first-time founders or younger founders.

00:18:31: Now you sit here because your an investor and we're interested in your view.

00:18:34: of course how does investors see convertible nodes?

00:18:37: If a company pops up on their deal flow says hey Christian would like have money.

00:18:41: do that change the world?

00:18:43: what's your view if these guys took convertible notes is more positive signalling or negative one?

00:18:49: It really depends on... ...the situation they are in.

00:18:55: It can be a sign of positive momentum.

00:18:58: Of investors wanting to go in quickly and sort-of, you know just securing their participation in the financing round regardless where ultimately the price comes out.

00:19:09: so it can't be positive or it can be aside of weakness because You know that?

00:19:14: The company has only been able secure financing for short period of time And hasn't been able to attract more money.

00:19:20: So if that's up to interpretation obviously founders are always inclined to make you believe as the first, even if it is a ladder.

00:19:28: You learn... ...to read between lines by experience and make that determination.

00:19:34: but so I would say either by default positive or negative.

00:19:38: It depends on what situation we think company actually currently in

00:19:44: Summing up.

00:19:45: We had advantages of being speedy like easy-to implement No pricing in the beginning.

00:19:51: Then we had disadvantages of having a investor with leverage.

00:19:55: It's also an unclear situation and sometimes negative signaling.

00:19:59: What would you recommend to young founders or two founders?

00:20:01: In general, is there rule-of-thumb?

00:20:03: Regarding convertibles which say I mean especially in Germany You have as far as I know The Hightech Gründerfonds Which are still used as convertible notes As financing instrument.

00:20:14: When do these things make sense for founders And when don't they?

00:20:17: That's very good question again unfortunately difficult to answer globally.

00:20:22: I think it depends on the type of investors you're talking too, if you are talking a set of investors that each do write relatively small check and end up raising from five or ten people without clear lead then thinking about convertible may be very good idea because You can get these people over-the line much more quickly when just say look If your fundamentally like what we were doing Just invest in the convertible And somebody down the road is going to price it on a far away and you get the benefit of a discount.

00:20:53: That allows people who are not used to setting up a valuation, to quickly commit.

00:20:57: so if your in that situation I think a convertible's good tool If you're talking one or two investors were gonna take sort-of an entire round then i think It usually better go straight for equity negotiate the price be done with it because Then you start really building your equity story.

00:21:12: You put stake at ground as where company from valuation perspective.

00:21:18: Okay, that's rather precise.

00:21:20: You just mentioned it.

00:21:21: It's hard to tell what this is actually a precise way of doing it.

00:21:24: Well then thanks a lot.

00:21:25: I think This gives us quite an idea of convertible notes.

00:21:27: and yeah Thanks for your time looking forward to the next episode.

00:21:30: Thank you same here.