Founders' Comprehensive Guide to Convertible Loans

Definition: What is a Convertible Loan?

The basis of a convertible loan is a regular loan with regular interest. The difference between this financing form and a normal loan is the option that the investor receives. This allows the investor the possibility to secure a stake in the company instead of repayment - sometimes at financially very attractive conditions.

Alongside the participatory loan, the convertible loan belongs to the mezzanine financing forms. The term is derived from the Italian word "mezzo", which translates to "half". A mezzanine financing is a mixed financing consisting of equity and debt capital.

Investors

Investors, who often participate in the start phase (seed phase) of a company, are also referred to as "business angels". Their name stems from the role they play for many young companies. They are often the saviors in times of need, giving a newly founded company the opportunity to implement its business concept and establish a foothold in the market. Business angels often bring in extensive know-how.

Venture capital is also a form of investment through equity capital injections (private equity). The biggest difference from business angels is that venture capital firms often provide higher sums. However, they usually only get involved in an advanced stage of the company, after the proof of concept. Venture capital providers typically focus primarily on the return on investment (ROI).

Advantages of Convertible Loans

Opportunity for Startups

Often, business models have high potential that cannot be fully exploited due to lack of financial resources. Here, the investor comes into play and provides the necessary startup assistance.

Quick Realization

While professional business plans are naturally desired by investors, the effort required for their creation is generally less compared to the traditional investment model, as they usually require less detail.

Business Network

Another advantage for founders is the large business network that often comes with an investor, offering opportunities for future networking. Business angels are often successful entrepreneurs or former entrepreneurs with excellent industry contacts.

Preservation of Decision Rights

The investor usually does not have direct decision-making or veto rights. Founders can therefore continue to act independently. They only need to comply with the information rights owed to them.

Attractive Benefits for the Investor

There are also advantages for the investor. While they still take on some risk, this is significantly smaller in relation to the invested amount compared to investing in an established company. Furthermore, there is the opportunity to secure profitable company shares at an attractive price by issuing a relatively small financing for most investors. They will always be in a better position than potential future investors.

Disadvantages of Convertible Loans

Financing Does Not Mean Advisory Duty

Even though you have the chance to hit the jackpot and benefit from professional support beyond the financial aspect, you should not expect this to be guaranteed. The investor is not obligated to do so. Their primary goal is almost always still to exit with the highest possible profit.

Cost Calculation

Do not forget that you owe your investor high discounts on company shares. Furthermore, investors are usually skilled negotiators. Keep this in mind!

Possible Difficulties in Finding Additional Investors

The comparison of shares with the initial investor initially makes a planned company participation appear unattractive to new investors. Therefore, finding new investors can be difficult in some cases.

Conflict of Interest

At the time of conversion, a conflict of interest arises, which can potentially lead to disputes between the parties. While as a founder, you want the highest possible valuation, a low valuation is advantageous for the business angel.

Worst-Case Scenario: Lack of Business Success

At the time of contract conclusion, both parties assume business success. But what if this doesn't materialize? At a certain stage, the core idea of the financing form, the conversion, no longer makes sense even for a business angel. In that case, they can still demand a payout of their financing amount. However, your company is likely to be in a second financial crisis at the same time. This can lead you deeper into debt. While it's usually the investor who loses out, as they come after all other creditors, you should still be aware of the great responsibility.

Functionality and Content of Convertible Loans

Contract Contents

A loan agreement should include at least the following points:

• Contract duration
• Interest rate
• Details of the payment method
• Discount rate for company shares
• Amount of the convertible loan

Special Agreements

Possible special agreements often tend to favor the investor. You should carefully consider whether you can agree to these beforehand. These may include, for example, a "Forced Conversion." Within this, the investor receives their shares at a fixed rate agreed upon before the contract is signed. In a "Valuation Cup," a maximum price for the valuation of your company is agreed upon.

Contract Conclusion and Its Pitfalls

It is often stated that a loan agreement for an agreed convertible loan does not require a specific legal form or notarial certification. In theory, this is true. There are also standard contracts that you can download online. Nevertheless, founders are advised to seek the assistance of a specialized lawyer. This is especially true when the agreed conversion occurs and the loan is converted into equity. This results in a capital increase and subsequent transfer of company shares to the investor. Then, legally speaking, the investor becomes a shareholder. Notarial certification is legally required in this case.

Contract Termination and Conversion

At the agreed end of the contract, the repayment of the loan is usually initiated, often in the form of conversion. The process itself is carried out by offsetting the purchase price with the loan.

Conclusion

Convertible loans represent an interesting opportunity, especially for startups, to quickly and easily obtain necessary funds. However, you should not be too easily tempted and protect yourself against "fallen angels." A specialized lawyer is an indispensable partner by your side and will competently advise you on implementing a loan agreement. This is especially true if the convertible loan is intended to be in your favor.

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