Article by Natalia de la Figuera – Co-Founder and COO of GENESIS Biomed

• The convertible note is a financing instrument that initially functions as a loan and is subsequently converted into a shareholding.

• The advantages of a convertible note are speed, simplicity, flexibility and avoidance of immediate dilution of partners.

• Particularly interesting for start-up/spin-offs in the field of biomedicine.

When a company, especially in its early stages, needs investment, there are different legal and financial tools to raise funding. Two of the most commonly used are the convertible note and the capital increase. Although both allow a company to raise funds in exchange for a future or immediate shareholding, their characteristics, advantages and disadvantages are very different. Below, we explain what each consists of and when it is appropriate to use one or the other.

Convertible Note

The convertible note (also known as a “convertible loan”) is a financing instrument that works initially like a loan, but with the particularity that instead of paying back the investor with interest, the investor will be able to convert the loan into shares in the company in a future funding round (usually an equity round).

The value at which this conversion takes place is usually lower than what new investors will pay in that future round, which represents an advantage for whoever invested first and took the higher risk. This is called a discount. In addition, many convertible notes include a “cap” or maximum valuation at which the loan can be converted, protecting the investor in case the company grows rapidly and its valuation skyrockets.

The advantages of this are:

• Speed and simplicity: It does not require an immediate valuation of the company, which facilitates quicker deals.
• Lower legal costs: As it is simpler than a capital increase, notary and legal costs are usually lower.
• Avoid immediate dilution: As the loan has not yet been converted into shares, there is no immediate dilution of existing shareholders.
• Time flexibility: One of the great advantages of the convertible note is that it can be used from the moment the company (be it a start-up or a spin-off) is formed, even if there is not yet a funding round on the horizon. This makes it possible to raise funds in very early stages, when a structured funding strategy has not yet been defined and there is no visibility on the timing of future rounds.

On the other hand, the disadvantages are:

• Uncertain future conversion: There may be disagreements if conversion terms are not well defined.
• Balance sheet impact: While it remains a loan, it appears as a debt in the accounting books.

Capital increase

A capital increase consists of issuing new shares in the company to bring in new investors, who in return contribute money directly to the share capital and/or share premium. This mechanism requires a valuation of the company at the time of the entry of new shareholders and leads to an immediate dilution of existing shareholders, proportional to the number of new shares issued.

This process is usually accompanied by a shareholders’ meeting, the execution of a deed in the presence of .a notary, and its registration in the Commercial Register, which makes it a more formal and complex procedure.

The advantages of this are:

• Legal and corporate clarity: New shareholders enter directly into the capital with all the rights that this entails.
• It does not generate debt: Unlike the convertible note, it does not appear as a liability on the company’s balance sheet.
• Immediate alignment: Investors already own shares from the outset, which favours a long-term relationship.

On the other hand, the disadvantages are:

• Need to value the company: In the early stages it can be difficult to establish a fair valuation, which can lead to conflicts between entrepreneurs and investors.
• Higher legal and notary costs: The transaction requires more time and resources to formalise.
• Immediate dilution: The founders and current shareholders see their percentage reduced as soon as the capital increase takes place.

Below is a comparative table of aspects to consider when choosing one financing tool over another:

However, the choice of one or the other tool for a start-up/spin-off to raise funds depends on factors such as the stage of development of the company, the urgency to raise funds, the type of investors involved and the medium- to long-term strategy. In the field of biomedicine, it is common to combine both mechanisms, typically using a convertible note prior to a funding round that leads to a structured capital increase. This provides a source of funding prior to the closing of a round, an arduous task that involves negotiation and a series of steps that usually entail a time delay, thus alleviating the situation of the start-up or spin-off until it materialises.