Convertible Loans for Startups: SA Guide to Early Funding

When it comes to financing your startup, most founders turn to private investors such as angel investors and venture capitalists. These investors are ideal for a tech startup; however, they are not the only option. Early-stage ventures need to be intentional with the funding mechanisms they choose, this way they can find the funding that aligns with their business needs, and one of those ways is convertible loans.

What Are Convertible Loans and How Do They Work?

Convertible loans are a type of short-term debt that can be (later) converted into equity in the borrowing company. This agreement is attractive for startups that need to raise capital early but are not ready for a traditional equity investment.

For founders who are unable or unwilling to use other agreements such as Simple Agreements for Future Equity (SAFEs), convertible loans offer flexibility while also offering early-stage investors downside protection. 

“This is debt. It’s not a permanent capital. The lender has the opportunity to convert it into permanent capital, but only under specific scenarios,” said Adrian Dommissee, Founder of Dommissee Attorneys.

Legal Compliance and the Companies Act

When it comes to legal compliance in South Africa, convertible loans are governed by the Companies Act of 2008. The Act does not clearly mention convertible loans, but it does regulate financial assistance under sections 44 and 45, which are relevant depending on the structure of the loan. 

Section 44 of the Act deals with financial assistance for the purchase of a company’s own securities or the securities of its holding company. In the context of convertible loans, this applies if the loan agreement allows the holder to convert the debt into shares. 

On the other hand, section 45 is applicable if the loan is made to any director or prescribed officer of the company.

Understanding these regulations is essential to ensure legal compliance and avoid complications when the conversion or repayment triggers occur. 

Key Terms in Convertible Loan Agreements

Much like any financial contract, convertible loans require carefully structured terms and clauses. Key elements include: 

· Principal amount – This is the original sum of money borrowed under the agreement.

· Interest rate – The percentage of the principal loan amount that is charged as a fee for borrowing, representing the cost of the loan.

· Maturity date – This is the date which the loan must be repaired or converted into equity.

· Conversion terms – The conditions under which the loan will convert into equity. This can include the triggering events for conversion, the conversion rate and any valuation cap or discount rate to be applied.

· Repayment terms – The conditions of the loan repayment in the event that it does not convert into equity.

· Security – If the loan is backed by assets of unsecured.

· Default provisions – The rights of the lender and obligations of the borrower in case the borrower defaults on the loan.

Legal risks and Dispute Considerations 

Convertible loan structures typically include warranties to protect the lender from any defaulting, and most agreements are structured after thorough due diligence. 

“The agreement might say: if you raise a minimum of R20 million at a post money valuation of R100 million within two years, then we have the right to convert. That doesn't really work,” cautions Dommissee. 

Startups who want convertible loans, should keep in mind the following considerations:

· Conversion price – The conversion price needs to be clearly defined and set at a discount to the next equity round’s price.

· Maturity date – The maturity date needs to be realistic so the loan can be repaid in time.

· Interest rate – Agree on an interest rate that compensates the investor without straining the company.

· Valuation cap – Include a valuation cap to provide security to investors and protect them from excessive dilution.

· Compliance – Always comply with local laws and regulations such as the Companies Act.

· Investor rights – Clearly outline investor rights, including any board seats or veto rights.

· Subordination clause – Consider including a subordination clause to manage the company’s debt hierarchy.

Convertible Loans vs Equity Financing: Pros and Cons

Unlike convertible loans, equity financing involves selling shares based on the startup’s current valuation. Convertible loans defer this valuation to a later stage, which can be advantageous if the valuation of the startup is still uncertain. 

Some startups may prefer convertible loans because of the benefits. These include:

· Faster execution – Convertible loans are typically quicker than equity financing, because of less documentation and negotiations. 

· Cost effective – Convertible loans typically involve fewer legal and administrative costs. 

· Preserves control – Lenders typically receive little control over the company operations; this works for startups still looking to raise capital or pivot.

· Delayed valuation – Because convertible loans are common in early-stage ventures, they postpone the decision of the startup’s valuation.

· Lower admin burden – Early-stage ventures typically have less shareholders, meaning less shareholder approval and red tape. 

“It's not Christmas, it's an equity investment. You're just receiving debt security in the meantime,” says Dommissee. 

The other side of convertible notes is the disadvantages. These can be:

· Debt risk – Convertible loans are debt, and it becomes a race against time to meet repayment terms. If the debt cannot be repaid, there may be repercussions not just for the business but investors as well.

· Complex conversion dynamics – Most convertible loans convert into shares, providing lenders with favourable conversion terms such as discounts plus liquidation preference. 

· Passive investors – Typically, the convertible loan investors take a hands-off approach, offering limited strategic support. 

Despite these drawbacks, convertible loans remain a compelling option for startups looking for quick and flexible financing mechanisms. 

Understanding the Tax Implications of Convertible Loans

Convertible loans, like other funding instruments (except grants) come with tax implications. While South African tax law does not provide a dedicated section for convertible loans, Section 8F of the Taxation Laws Amendment Act applies to hybrid debt instruments, into which most convertible loans fall. 

Under section 8F, if a loan converts into shares whose market value is less than the outstanding debt, it may be taxed as a dividend in specie. Conversely, if the shares are worth more than the debt, the loan issuer is seen to have redeemed the debt at a premium, potentially attracting tax implications. 

However, there is an exception: if the market value of the shares at the time of conversion is equal to the debt owed, then the instrument may not trigger adverse tax treatment. 

It’s essential that founders and their legal advisors ensure the conversion mechanics are designed to comply with the provisions and exceptions of section 8F to avoid unintended tax liabilities. 

Convertible loans provide early-stage startups with a flexible funding tool. By delaying valuation, preserving control and streamlining the funding process , they serve as a valuable bridge to more permanent capital.