Are convertibles suitable for your startup?

Several months ago (well before the confinement), I attended a conference at Silversquare given by Cohabs CEO, Youri Dauber. When I asked him how he felt about the ownership dilution effect because of the two previous fundraising processes his startup went through, he smiled unexpectedly. He said that the Cohabs founders did not feel angry about it because they managed to keep a large portion of their equity while giving to external investors only a small fraction of it. Obviously, real estate is a good sector because you can use a lot of debt to fuel your growth, therefore retaining a substantial ownership. However, Youri also mentioned that he was using a lot of convertibles – a very smart decision.

Convertibles are of course very useful for startup founders who wish to keep their ownership high while growing. But you should be careful when using them because you might think you are safe but just be delaying the dilution.

Convertibles are financial securities used in many types of fundraising, not only with startups. Convertibles (also called ‘convertible debt’) is one type of quasi-equity, i.e. a security which has mixed features of shares and debt. Convertibles are actually a contract whereby a lender may convert their claim into equity at certain milestones or at a pre-set maturity. The lender can therefore become a shareholder of the company, but in the future.

Convertibles are of course very useful for startup founders who wish to keep their ownership high while growing.

Most frequently, the milestones that trigger the conversion are capital increases and they include a preferred price for the lender, say a discount of 25%. Loans are generally ‘bullet’, meaning no interests are paid before maturity or conversion, and bear a substantial interest rate which can go up to as much as 7% or 8%.

Consider the following example: VeloCity Bikes is a startup which is worth €1.5m. It raises capital via the issuance of a 2-year bullet Convertibles with 8% interest rate per annum. Convertibles holders have negotiated that at maturity, conversion will occur at a 25%-discount.

After two years, Convertibles holders decide to convert their loan and at that time, VeloCity Bikes is now worth €10m.

With a compound interest rate of 8% per annum, the convertibles value is now €1.75m. During the loan conversion (a capital increase), 424 new shares are created at a per share value of €4,125. Founders are diluted with 22%.

This is however a much better situation than the 50%-dilution if VeloCity Bikes had directly opted to raise equity in place of convertible debt.

Convertibles: for me or not for me?

In a perfect world, founders should keep a substantial portion of their company’s equity. Founders are actually the engine under the car bonnet – you should always make sure it works properly.

Convertibles are very useful financial instruments to reduce the founders’ dilution effect and thus allow them to keep a bigger portion of the cake. However, you should never hide them under the carpet and pretend they are not there – eventually, you might lose a lot of ownership, especially if convertibles holders have negotiated a large discount.

Never forget that a good deal is not a deal which is optimized just from a financial point of view, but also a deal with a new structure you feel comfortable in (i.e. with consistent corporate governance) and legally safe (i.e. with enough legal protection).