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The convertible loan as an alternative to VC financing
Is a convertible loan the right choice?
What are convertible loans?
A convertible loan is initially an ordinary loan (loan agreement), which, however, comes with the option or the obligation for the lender to convert his loan into a stake in the company in which he is investing under certain circumstances. Thus, the loan debt can or must be converted into a company participation at a later date, so that the investor participates in the start-up. Therefore, the lender does not acquire an ordinary claim for repayment through the loan agreement concluded, but shares in the company. If the loan is converted into shares for the investor, a capital increase must take place at the start-up in order to create new shares. These are then taken over by the investor.
The lender may be a third party outside the start-up, but it may also be a shareholder in the company. In the loan agreement, the lender and the borrower usually agree on the principal amount of the investment, the interest, the duration of the investment and the terms of a conversion into company shares.
When should a convertible loan be considered?
Convertible loans are particularly relevant for start-ups in the context of start-up and bridge financing. Often, start-ups have a product idea in the early stages of their development but no financial resources. In such cases, a convertible loan can be considered as start-up financing to enable the company to, for example, start developing its products.
Another possible scenario is that the start-up has already completed an initial financing round (Series A) and a second financing round (Series B) is in prospect, but the current financing is not sufficient to bridge the time until the subsequent financing round is completed. In this case, a convertible loan can provide useful interim financing.
What do you need to watch out for with a convertible loan?
First of all, it is important that, in the event of the loan being converted into a company participation of the investor, an effective capital increase takes place in the start-up. To this end, all shareholders should be obliged with regard to the conversion right, so that an effective decision can be made to increase the capital. This can be implemented if all shareholders become parties to the participation contract.
The creation of new shares (capital increase) usually means that the start-up’s articles of association have to be amended. However, this can be done without observing any particular form. If the participation agreement stipulates that the investor is obliged to acquire shares in the company, the participation agreement must be notarised in this case, as the obligation to acquire shares in the company must be notarised.
Advantages and disadvantages of the convertible loan for the start-up
For a start-up as borrower, a convertible loan has the particular advantage that no company valuation is necessary for this type of financing. Especially in the case of VC financing, a detailed company valuation is usually necessary, which in turn often requires an annual forecast of 3-4 years and a comprehensive business plan. This is not necessary with a convertible loan, which makes it possible for a younger or smaller start-up to realise a convertible loan.
Thus, convertible loans are also a faster form of financing, since there is no need for founders, old and new investors to negotiate and agree on the valuation of the start-up. Although a convertible loan does not come entirely without some kind of valuation of the company, it is sufficient to simply refer to the upcoming financing round and use this value as a still-open reference point for the question of how many shares the investor will receive when the loan is converted. By eliminating the need to answer the specific question of valuation, the investment process can be accelerated, enabling start-ups to receive their financing more quickly.
In addition, the convertible loan is often based on a straightforward loan agreement with limited provisions due to the simplicity of a loan. While complicated and extensive contracts have to be negotiated for VC financing, the convertible loan requires a loan agreement that is not too extensive.
Likewise, convertible loans can easily align the interests of the start-up and the lender, because the typical subjects of a loan agreement are not subject to any special legal regulations. Therefore, a convertible loan agreement is open to a variety of individual arrangements and thus particularly flexible for the contracting parties.
However, the disadvantage of a convertible loan for a start-up is that the loan weighs on the company as a liability. Furthermore, the company does not have the option of triggering the conversion of the loan itself, which can affect the financial flexibility of the start-up..
Advantages and disadvantages of the convertible loan for the investor
For the investor, the convertible loan offers low transaction costs, since it is basically an ordinary loan. The loan agreement can also be flexibly structured for the lender and is therefore considered uncomplicated.
However, especially in comparison to VC financing, the convertible loan has a crucial difference for the lender: convertible loans do not give the investor any rights to participate in the start-up. Convertible loans are also generally unsecured and are treated as subordinate. This means that in the event of the start-up’s insolvency, the investor, as the lender, has no security to fall back on. Furthermore, the investor is subordinate to all the start-up’s other creditors, which means that the other creditors take precedence over the investor in the event of insolvency. This means that the lender runs the risk of the loan amount possibly not being offset by any valuable assets in the company.
For the investor, the convertible loan offers low transaction costs, since it is basically an ordinary loan. The loan agreement can also be flexibly structured for the lender and is therefore considered uncomplicated.
However, especially in comparison to VC financing, the convertible loan has a crucial difference for the lender: convertible loans do not give the investor any rights to participate in the start-up. Convertible loans are also generally unsecured and are treated as subordinate. This means that in the event of the start-up’s insolvency, the investor, as the lender, has no security to fall back on. Furthermore, the investor is subordinate to all the start-up’s other creditors, which means that the other creditors take precedence over the investor in the event of insolvency. This means that the lender runs the risk of the loan amount possibly not being covered by the company’s valuable assets.
Conclusion: Is a convertible loan a sensible alternative to VC financing?
Whether a convertible loan is a viable alternative to VC financing must be decided on a case-by-case basis.
If the start-up is still in the early stages of its entrepreneurial activity, convertible loans for smaller financing amounts generally make sense for both the start-up and the investor. With smaller amounts, the investor’s risk of loss is limited and the convertible loan is easy to implement.
However, it is particularly important for convertible loans to be unambiguous and complete so that the conversion mechanism works and no additional risks arise for the investor and the start-up.
