Convertible Loan Agreements (CLAs) have become a popular financing tool for startups, offering flexibility and delaying the need for immediate valuation discussions. However, while they provide advantages, they also come with potential pitfalls that entrepreneurs and investors should be aware of. In this blog, we will explore the most common mistakes and how to avoid them.
1. Unclear Conversion Terms
A common issue with CLAs is vague or overly complicated conversion terms. If the agreement doesn’t clearly define when and how the loan will convert into equity, it can lead to disputes and misunderstandings.
How to avoid it: Ensure that your CLA explicitly states the conversion trigger events, valuation cap, discount rate, and any other relevant conditions. Both parties should fully understand the implications before signing.
2. Unrealistic or No Valuation Cap
A valuation cap sets a maximum price at which the loan converts into equity. Without a cap, investors could end up with fewer shares than expected if the company’s valuation skyrockets. On the other hand, an unrealistic valuation cap might deter investors.
How to avoid it: Establish a fair and reasonable valuation cap that balances the interests of both the startup and the investor. Seek professional guidance to determine an appropriate range.
3. Ignoring Interest Accrual
Some CLAs include an interest component that accrues over time. Entrepreneurs often overlook this aspect, leading to a higher total amount that converts into equity.
How to avoid it: Understand the interest rate and its impact on dilution. If possible, negotiate a fair interest structure or consider alternatives such as simple interest rather than compounding.
4. Lack of a Maturity Date Plan
Convertible loans typically have a maturity date, at which point the loan must either convert or be repaid. If the startup has not raised a qualifying round by then, this can create financial strain.
How to avoid it: Define clear strategies for handling maturity dates. Include clauses that allow extensions or specify what happens if conversion does not occur within the agreed timeframe.
5. Multiple CLAs with Conflicting Terms
Startups often raise multiple convertible loans at different times, leading to a complex web of agreements with inconsistent terms.
How to avoid it: Maintain consistency across different CLAs and align them with future fundraising rounds. Having a legal expert review all agreements helps ensure compatibility.
6. Dilution Surprises
Entrepreneurs sometimes underestimate how much ownership they will lose once the loan converts into equity, especially if multiple investors are involved.
How to avoid it: Use financial modeling to project ownership dilution before finalizing any CLA. Transparency with investors about expected dilution fosters better long-term relationships.
7. Failure to Consider Tax Implications
Both startups and investors should be aware of potential tax consequences related to interest accrual, debt forgiveness, or equity conversion.
How to avoid it: Consult with a tax professional to understand the implications in your jurisdiction and ensure compliance with tax laws.
Final Thoughts
While Convertible Loan Agreements are a powerful tool for startup financing, they require careful planning and negotiation. By addressing potential pitfalls early on, both founders and investors can create agreements that benefit all parties and support long-term growth.
If you're considering a CLA, seek advice from legal and financial experts to ensure a smooth and fair agreement.
How Share Council Can Help
Navigating convertible loan agreements can be complex, but Share Council is here to help. Our team of experts provides clear legal and financial guidance, ensuring that your agreements are structured to protect both your startup and your investors. Whether you need help drafting terms, understanding dilution, or planning for conversion, we offer the tools and expertise to make the process seamless. Get in touch with us today to see how we can support your growth!
