The convertible loan as an alternative to VC financing

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. 

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The Term-Sheet

The Term Sheet

WHY A TERM SHEET IS IMPORTANT WHEN INVESTING IN A START-UP

Investing in a start-up can be a complex process during which it is important to weigh up all the risk factors and make the investment secure. The interests of the investor and those of the start-up should be taken into account in an appropriate balance, thus it makes sense to formulate and agree on the framework conditions of the investment before starting negotiations on the investment agreement.

A term sheet can be used as such a framework agreement. This article explains what a term sheet is, what exactly it is used for and what a meaningful term sheet should contain.

What is a term sheet and what is it needed for?

The term sheet is a central component of the process of investing in a start-up and a framework agreement between the start-up and the investor that is used as the basis for the investment and the preceding negotiations.

The term sheet is thus a basic document that contains the most important key points of a planned investment, important conditions, future terms and the ideas of the parties and serves as a binding basis for the design of the future participation agreement. The term sheet therefore serves to provide the parties with planning security and ensures that the parties’ contract negotiations and discussions are conducted in accordance with the conditions and principles described herein. Although the term sheet does not legally oblige the parties to conclude an investment contract, the clauses and principles formulated in the term sheet are binding.

The term sheet provides the parties to the planned investment with a structured overview of the desired course of the investment and any possible scheduling. It serves as an initial basis for clauses, rules and conditions and is intended to accelerate lengthy contract negotiations.

What can and should be regulated in a term sheet?

A term sheet has no substantive limits, so that the parties are initially free in terms of content. It can therefore cover everything from ideas and wishes regarding the investment, to the course of the investment, to the investor’s exit. All the key points for the parties can thus be included in the term sheet.

However, a term sheet should always include the time frame for the planned investment negotiations, the amount of financing and the investor’s stake, the use of funds, guarantees for the investor, the start-up’s valuation method, an exit clause and a confidentiality agreement.

A good term sheet is characterised by a specific and concise regulation of the most important cornerstones of the planned investment. While it should cover all the necessary points, the document should not be ‘overloaded’.

The valuation of the start-up as the central question

The valuation of the start-up is one of the main points to be negotiated in a term sheet. This is due to the valuation being the basis for determining the amount in which the investor will participate. The higher a company is valued, the less the founders’ participation rate decreases for a certain investment amount.

Since a start-up usually does not yet have a lot of reliable financial data, the valuation of a start-up is mainly based on future, forecast developments and on the potential demand for the start-up’s product on the market. For such a forecast, it is crucial, for example, whether there are many competing companies developing similar products, whether the product is likely to appeal to a wide range of customers and how the general future economic situation is generally assessed. 

We would be happy to advise and support you with our expertise in planning and creating a term sheet of this kind.

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