Convertible loan for german startups
Financing startups in Germany before and between financing rounds through mezzanine capital
Alongside ordinary loans and genuine equity investments, convertible loans are a straightforward way of financing startups in Germany. A convertible loan is mezzanine capital. The convertible loan offers VC investors and other financial investors as well as founders and existing shareholders a sensible form of financing in german practice.
What are the advantages of a convertible loan compared to other forms of financing, what is regulated in a convertible loan agreement and what else there is to consider under german law, you can read below.
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Our expertise on convertible loans, convertible loan agreements for german startups
Our dynamic VC / startup team, consisting of certified specialists and tax advisors, advises founders, investors and startups in Hamburg, Berlin, Munich, Frankfurt, Cologne and nationwide on all legal and tax issues related to convertible loans as an alternative for raising capital. Our advisory spectrum includes in particular:
- Strategic, legal and tax advice in the run-up to financing, in particular through convertible loans
- Drafting and negotiation of convertible loan agreements, contract documentation
- Accompaniment of "convertible loan financing rounds
- Coordination of convertible loan agreements with investment and shareholder's agreements (ISHA)
- Review and negotiation of convertible loan agreements
- Execution of conversions of a loan into real equity participation (business shares), support of capital increases
- Strategic advice and (judicial) enforcement of claims arising from convertible loan agreements
What is a convertible loan under german law?
A convertible loan is an ordinary loan (credit agreement) combined with the option or obligation of the lender to convert its loan into a real GmbH participation under certain circumstances.
Typical for convertible loans in Germany is that they are unsecured and subordinated. In the event of the startup's insolvency, the investor as lender therefore has no security whatsoever; he also ranks behind all other creditors ("comes last"). In this respect, the convertible loan is similar to real equity in german practice.
What are the advantages of a convertible loan in german practice?
The advantages of a convertible loan over other forms of financing - such as ordinary credit agreements and ordinary financing rounds - can be simplified into three words: fast, uncomplicated, flexible.
Convertible loans are fast because negotiation and agreement between founders, old investors and new investors on the valuation of the startup is usually not necessary in german practice. In financing rounds, there are usually hard and also long commercial arguments about the valuation of the german startup. The valuation is the all-important factor in determining how much founders and any old investors have to give up from their stake in Germany. This in turn decides on majorities and shares in the exit proceeds.
Since even a convertible loan cannot do without any reference to a valuation, a simple "trick" is used in german practice. One simply refers to the valuation in the next financing round. This is then the reference point for the question of how many shares / business shares the investor (convertible lender) receives upon conversion of his loan.
In german practice, the elimination of the valuation of the startup is accompanied by an immense acceleration of the financing process. Some say that convertible loan agreements can be closed at lunch. This may not be entirely true, but it is a reflection of the comparative speed with which capital is available through convertible loans in Germany.
Convertible loans are uncomplicated in german practice because the contracts required for them are simply structured. Convertible loan contracts usually follow a simple, clear scheme. The reason for this is that the individual points requiring regulation (see below) are limited compared to alternative forms of financing. For example, convertible loan agreements are usually no longer than 5 pages, while investment contracts / participation agreements often run to 20, 30 or even 50 pages.
Convertible loans are flexible because they can easily bring together the interests of the parties involved - the founders and old investors on the one hand and the new investors (convertible lenders) on the other. This is mainly due to the fact that the subjects which are typically regulated in a convertible loan agreement (for this, see below) are not subject to any special statutory regulations and are by nature open to various formulations under german law.
When is a convertible loan worthwhile in german practice?
In line with their advantages, convertible loans are primarily used to provide start-up and bridge financing for young german companies.
Early stage
The first classic area of application for convertible loans is therefore the early phase of german start-ups. Example: The founders have a great product idea, but unfortunately their own financial resources are not sufficient for the start, especially the first months. Example: product development is underway, own and first external funding (EXIST programs, accelerator programs) have been used up, but somehow the product is not ready yet and also the completion maybe not yet horizon.
In both situations, it may still be too "early" for a "real" financing round in Germany. Here, early financing by means of a convertible loan can be a sensible alternative.
Bridge financing under german law
The second classic area of application for convertible loans is bridge financing. Example: The german startup is doing well and has already completed the first round of financing (Series A); the second round (Series B) is already on the horizon. However, it is foreseeable that the liquidity will not be sufficient until the final closing of the Series B. The quick closing of the Series B is also a good solution in this situation.
In this situation, too, the quickly concluded convertible loan with a corresponding injection of funds is a sensible bridge financing option.
What should be regulated in the german convertible loan agreement?
Convertible loan agreements essentially consist of four building blocks in german practice. These are regulations
- on the loan agreement, including interest rate regulations
- on the conversion ("equity kicker" in the form of subscription rights)
- on any special investor rights
- on the subordination of the investor (subordination)
1. The provisions on the loan relate to the classic aspects of a loan agreement in Germany. These include
- the amount of the convertible loan
- interests, the date when the interests are due
- Conditions for disbursement of the convertible loan (timing, conditions, milestones, trigger events)
- the duration of the convertible loan
2. The provisions on conversion usually take up a large amount of space; in germab practice, they also vary considerably due to the wide range of possible arrangements:
- Right or obligation of the investor (convertible lender) for conversion
- "Calculation formula" for the number of shares that the investor receives on conversion
- Securing of conversion, especially obligation to increase capital
- Consequences of non-conversion, above all repayment date, final maturity of interest
An important aspect at this point is, of course, the "calculation formula" for the number of shares the investor will receive upon conversion. The starting point of the calculation is usually a discount on the valuation of the german startup in the next financing round. This valuation discount often varies between 15 and 40% in german practice, but is ultimately a matter of negotiation between the parties involved.
In addition, a valuation floor (minimum valuation) or valuation cap (maximum valuation) can also be agreed in order to be able to take into account special "swings" in the valuation upwards and downwards. So-called variable or floating discounts are also conceivable in Germany - with these, the discount amount varies, e.g., depending on the period of time until the next financing round.
3. The provisions on any special investors relate on the one hand to the information rights and approval rights of the investor as lender to management measures, which are also anchored in many classic loan agreements.
However, they also relate to any preferential rights of the investor with regard to exit proceeds (liquidation preferences), protection against dilution (anti-dilution) and equal / better treatment with subsequent investors (most-favored-nation clause).
4. The subordination of the investor in german practice means that in the event of over-indebtedness, the convertible loan in Germany is not treated as "debt" in the balance sheet, but is in fact treated as equity.
How does the conversion take place under german law?
The conversion of the loan into real shares, in the case of a german startup GmbH into real business shares, usually takes place in the context of a capital increase (increase in share capital). If the conversion event occurs, the shareholders of the german startup decide to increase the capital. In this way, they create new shares, which are taken over by investors.
The shares in german practice are usually taken over at the nominal value of 1 EUR, the loan portion is contributed by the investor as a premium (agio). For accounting in Germany, see below.
With regard to the number of shares which the investor receives and which are therefore to be created within the framework of the capital increase, the agreed calculation formula (see above) is decisive.
The capital increase resolution requires a majority of 75% and notarization under german law.
It should be noted that in the case of bilateral convertible loans (contract between lender and startup), the shareholders are not obliged to increase the capital directly from the loan agreement. What is indicated in the case of bilateral convertible loan agreements in Germany is an authorizing resolution of the shareholders' meeting authorizing the management of the startup to conclude the loan agreement. However, such a direct obligation of the shareholders to increase the capital arises from multilateral convertible loan agreements in which the shareholders of the german startup are also contracting parties.
It is also conceivable to convert the loan within the framework of the so-called authorized capital in german practice. In simplified terms, authorized capital is an anticipated capital increase with the authorization for the management to issue new shares for the conversion.
Does the convertible loan agreement have to be notarized in Germany? Notary?
Whether a convertible loan agreement requires notarization under german law is a matter of legal dispute and depends to a large extent on the specific form and any accompanying documents. In particular, the inclusion of shareholder agreements / participation agreements with typical clauses (e.g. drag along, take along) may trigger a notarization requirement with the german notary.
In german practice, it can be observed that the parties involved often deliberately forego notarization in the interest of simplifying and accelerating the investment process, thereby accepting a possible ineffectiveness.
Accounting for the conversion (posting the convertible loan) under german law
In the case of the german company receiving the convertible loan, the agio (premium) is posted to the free capital reserve (posting in accordance with section 272 (2) no. 4 of the German Commercial Code (HGB)). The convertible loan is therefore recognized on the liabilities side of the balance sheet under equity.
Example of calculation for convertible loan in Germany (without cap/floor)
The starting points are as follows: Startup GmbH with 25,000 shares at EUR 1 each, convertible loan amount EUR 100,000, term 2 years, agreed valuation discount 25%, no floor / cap.
Before the end of the term of the convertible loan, another financing round takes place in Germany. In this round, the start-up is valued at 1 million EUR. One share therefore has a value of 40 EUR (1,000,000 EUR / 25,000 shares = 40 EUR).
The convertible lender has a claim to shares in the amount of his convertible loan, i.e. 100,000 EUR. According to the agreement, he receives a valuation discount of 25%. Instead of 40 EUR, a share therefore costs him only 30 EUR. Since he has to pay a nominal amount of 1 EUR for each share as part of the capital increase, his price per share is ultimately reduced to 29 EUR.
The total claim of the convertible lender (here 100,000 EUR) is now divided by the price per share (29 EUR). This results in the number of shares that the convertible lender receives: in this case 3,448 shares, i.e. his pre-money shareholding is 12.12%.
