Convertible notes can be a useful tool for supporting external innovation

On the topic of convertible loan notes and corporate venture capital for banks. If you're a bank looking to work with FinTech *start-ups*, these can be absolutely fantastic tools both for you and the start-up. I am continually astonished by how overlooked these are when it comes to exploring and supporting effective external innovation.

I saw a post yesterday by Sifted that was exploring the whole issue and, although the author did a great overview, they (and those interviewed) didn't explore the significance of convertibles for this particular use case:

So here's an example situation (and I'm writing from the point of view of working in a digital / transformation or innovation area in a bank):

You are a big globally systemically important bank. You want to innovate and you realise that doing anything internal is often the anthesis to innovation so you also explore working with third parties. (I know some internal innovation can work quite well, but generally, there's a lot of innovation theatre and limited value output). Often these third parties ('start-ups') that you'd like to work with are very new or they are 1-3 person organisations, usually unproven. The start-ups present some great mock-ups and you can see their idea could potentially turn into either a product your business line would absolutely kill for, or perhaps it could even become a significant offering for the whole of a particular business division.

But how do you get money into the start-up in an effective manner? Usually, you have to 'innovate' with your budgets, try and get the procurement team to understand, and end up giving some 'sponsorship' budget or buying a 'proof of concept project' from the start-up. Both are a bit limited because although they do buy some degree of loyalty from the start-up, there's nothing to bind you together beyond a rather lightweight contract (if there is even that). They can take your sponsorship and massive industry name and walk into the competitor's HQ the next day.

What if there was a way to keep encouraging innovation in the start-up, to carefully observe and watch how the concept evolves? To work with the team as they design and improve the product.... and give them a bit of working capital to hire a few resources temporarily as needed? Sometimes it's just EUR 5k. Sometimes 25k or 50k. Often you might start with 5k or 10k... then see how things go... add another 10k as the start-up is evidencing they can deliver.

You're also increasing confidence with the start-up team - usually 1-3 people - who, without your attention and funding, were rummaging around trying to arrange seed and friends and family funding. But your ability to inject cash rapidly is keeping them focused on solving your problems. It's helping them ignore job offers and interest from other banks too. It's also keeping friends, spouses and parents happy. ("Oh why can't you just get a proper job").

In a financial services player where standing up a basic project costs a minimum of 500k EUR (and really, can't properly start until you've hit 1M EUR), the figures we are talking about are small. It's rare that a CEO of a bank will object to you spending 10, 20, 50 thousand pounds, dollars, euros on such an activity, provided you are consistently able to show value on a weekly or monthly basis.

In this context, the value for the bank is learning, or screenshots, mock-ups or actually sitting with clients of the bank and showing them the new product idea (designed by the start-up) and then iterating on a weekly basis with the client. This kind of activity is gold dust when it comes to growing and developing existing bank relationships with seriously important clients.

But how do you actually get the money into the start-up? And how do you retain some degree of 'skin' or value or influence as you help the start-up rocket through the innovation cycle and emerge with product-market-fit for a global bank?

A convertible loan note!

Most who have any experience with convertibles (as commented in the Sifted article) will raise the metaphorical cross immediately ("be gone, thou horrid convertible"). They have a bad reputation in some areas because people associate them with bridge financing and predatory VC tactics.

No, if you can create a fair and reasonable loan note, they can be tremendously effective.

Here's how it works.

We come up with a number. 10k Euro. 25k Euro. Something like that. Larger is possible but baby steps are also helpful in this regard.

We create a convertible loan agreement. I will lend you 25k Euro. I can convert this amount into stock in your company at a later date, on some specific terms. I think it's crucial for the terms to be friendly, fair and appropriate.

"Ah but why don't you buy equity?" asks the start-up founder.

"Yeah, no." We reply. You're not at all proven. We will choose when and if we convert the loan. In many cases, we won't bother asking for the money back and will write it off if the company/idea/project/process goes nowhere.

Now it's at this point someone in the CFO organisation has a minor metaphorical heart attack. Someone in the business division who supervises lending too. Because:

1) You're talking about a loan to a company that would never, ever get approved in standard circumstances (and you're a bank, so, there are established processes for this, and since we're a bank, we stick-to-process, right?)

2) You're talking about the possibility of never actually calling the loan? Yes because it's a start-up and the idea we're both working on might go nowhere. Writing it off is quick, simple and easy.

3) there are (small, small) ramifications for a bank making a loan and then writing it off later on. Most business banking executives will be able to handle this easily and understand that the amounts are not material and that this is an entirely different situation than standard lending. Still, you're a bank: So cross the t's and dot the i's.

So there are some issues that in some organisations could well be insurmountable. But others will be able to handle it.

Now then, since you've got an instrument that enables you to fund easily and quickly, you can get back to the business of focusing on the work with you and the start-up.

Let's say they've created a tool that enables a specific function for a customer. Or maybe it helps your relationship managers predict the solvency of customers. Or perhaps it's a tool that scans your local market for business insight.... whatever. You've given 10k Euro in a convertible and that enabled the start-up to deliver a working mock-up. You then gave a further 25k to help them hire a few developers temporarily and make the thing into a working prototype. The money also helped them buy some specialist legal advice and to buy the right Amazon or Azure infrastructure that you, as the bank partner, want them to be operating.

You've spent 35k so far.

You take the concept to the Chief Business Officer, or the relevant group executive. They've been involved loosely at each stage so this isn't a surprise. If anything, one of their direct reports will have been closely involved in every bit of this stage. The CBO listens, watches, asks questions and then green lights the next stage: Live testing with clients and customer data.

You authorise another convertible note of 25k or 50k; because now you need to make sure the start-up has engineers on-demand and ready, that their infrastructure is totally sound (as we're talking customers and customer data here). So they need resources to get this in place.

You run the pilot.

You're back with the CBO and a successful pilot where you've learned quite a bit. Since you're a bank, you decide to do another pilot. A bigger one though. This might need additional funding. But usually, at this point, there's enough interest from seed and angel investors who have been watching on the sidelines.

It's an interesting question at this point: Do you want the start-up to take third-party investment? Normally the answer is yes and always. But there are situations where it might be better to be the start-up's only source of funding, especially if you can see a need or a desire to fully acquire the company. The right step in this regard is contextual.

After the big pilot, the CBO is convinced. The CEO has been following along. Perhaps the board has been informed of this great new innovation too.

I'm painting a rosy, positive picture, to explore the various milestones.

When it comes to deploying the product into production, you've had to sit down with the start-up and work out how the revenue works. How do you pay them? How does the value exchange work? Is the end bank customer billed for the service? Is this a cost that the bank pays? Is there a sufficient budget allocation from the business division?

You could consider buying the company totally. It's only got one client, you. You know you want the product. You can construct the deal with the start-up nicely. You've already got the convertible sitting there and depending on the terms you've agreed, you could either participate in an equity funding round with other angels/VCs, or you could simply acqui-hire the company.

There are, I appreciate, a lot of holes in this concept because every bank is different, every start-up is different and - of course - every jurisdiction is different. In some countries, you simply can't use this kind of instrument effectively.

I felt it was important to highlight that there can be a really useful way of deploying convertible notes with start-ups to help the innovation process.

[Photo credit by?Cytonn Photography?on?Unsplash]