How does a Convertible Loan Agreement differ from a Traditional Loan Agreement?

A convertible loan agreement differs from a traditional loan agreement in several key ways:

1. Conversion to Equity: The main distinguishing feature of a convertible loan is that the debt can be converted into equity (ownership shares) of the company at a later date. This is not an option with a traditional loan, which must be repaid in cash.
2. Valuation: With a traditional loan, there is no need to determine the company’s valuation. However, with a convertible loan, the valuation becomes important as it determines the number of shares the loan will convert into upon a conversion event.
3. Conversion Terms: Convertible loan agreements specify the terms under which the debt will convert to equity, such as:
   • Conversion discount (e.g. 20% discount on next equity round price)
   • Valuation cap (maximum valuation for conversion pricing)
   • Qualified financing threshold (minimum equity financing size to trigger conversion)
   • Maturity date (if not converted by this date, the loan must be repaid)
4. Interest: Convertible loans typically have lower interest rates compared to traditional loans, as the investor expects to gain through the equity conversion.
5. Investor Rights: In a convertible loan, the investor is initially a lender and does not have shareholder rights until conversion. Traditional loans do not provide investor rights.
6. Repayment: If the convertible loan does not convert to equity by the maturity date, it must be repaid like a traditional loan. However, traditional loans have a defined repayment schedule from the outset.
7. Complexity: Convertible loan agreements are more complex than traditional loans due to the equity conversion terms and mechanisms involved.

In essence, a convertible loan blends aspects of debt and equity financing, providing investors with more upside potential compared to a traditional loan, but also more complexity in terms of valuation, conversion rights, and shareholder considerations.

Citations:
[1] https://hedman.legal/articles/convertible-loans/
[2] https://www.verve.vc/info-convertible-loan/
[3] https://www.netocratic.com/convertible-loan-for-startups-89055
[4] https://www.re-cap.com/financing-instruments/convertible-loan
[5] https://harperjames.co.uk/article/convertible-loan-note-explained/

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