Convertible loans on the upswing
Convertible loans have always been popular as a way to avoid difficult valuation discussions in the early stages of a business or to bridge short-term financing needs until a larger round of financing is available. In times of high valuation volatility and difficult external circumstances, it is therefore not surprising that companies very much like to seek internal and also external financing via convertible loans in order to save transaction costs on the one hand, but also to try to avoid external signs of current valuation restraint on the other. Convertible loans are designed to be converted in full into equity at a later date, i.e. they contain the right or obligation to subscribe for shares in the Company in return for the claims arising from the loan in the event of a capital increase.
This distinguishes them from venture debt, which is loan financing for young companies that are not yet able to obtain financing from a bank in the early stages due to a lack of collateral. In contrast to convertible loans, venture debt does not dilute existing shareholders much, if at all. Hardly, because many of the venture debt contracts include a so-called warrant , which contains a conversion right for part of the loan or is at least economically modeled on a convertible loan. Venture debt contracts are often chosen by companies that expect sharply rising valuations above the interest rate on the venture debt.
According to the correct view, convertible loans do not have to be notarized. At least not if they are concluded with all shareholders. Any conversion obligation is then structured as a pure voting obligation of the shareholders, which is possible without any formalities. Convertible loans with a conversion obligation concluded purely bilaterally with the Company are currently under discussion as being subject to notarization or even authentication. We therefore advise the former design variant.
Despite the availability of sample contracts on the web, professional support is recommended when concluding convertible loans. Not only must the conversion mechanism be neatly regulated. Situations in which the loan is to be converted, such as whether only one side is to be entitled or both, or even whether there are to be conversion obligations, also require clear regulation in order to avoid disputes. In addition, convertible loans can include agreements that are otherwise more typical of equity financing rounds, such as information or even veto rights.
If the contract does not contain any provision on the sale of the company, it continues to run in principle. However, this is usually not in the interest of the parties. Therefore, this case should be clearly regulated. A right of termination with repayment, also with a bonus, a so-called exit kicker, can be considered. However, prior conversion would also be possible, in which case it must be clarified at what valuation. Usually, the investor will want to participate in a successful exit, so either a discount or a maximum valuation is set. In this way, the investor can secure the same opportunity as if he had participated in the company’s equity from the outset.
About Björn Weidehaas
Björn Weidehaas advises family offices, funds, business angels and start-ups holistically during the financing phases as well as companies during restructurings and in insolvency law. As a business graduate, he understands the complex economic interests of his clients.