What has long been the standard for startup financing in Silicon Valley is also becoming increasingly popular in Germany: the convertible loan (also known as SAFE).
The convertible loan offers German startups an attractive alternative to traditional financing rounds. This blog post is part of our series on convertible loans. In this blog post we will explain the concept of a convertible loan using a simple example and show the advantages of convertible loans compared to traditional financing rounds. The second part will focus on the conversion and explain typical provisions in convertible loan agreements such as interest rate, discount and cap valuation.
What is a convertible loan?
A convertible loan is a form of corporate finance in which an investor provides the company with a loan that can be converted into shares in the company at a later date. Unlike a traditional loan, the loan amount of a convertible loan does not have to be repaid, but is converted into equity when certain events occur (such as the next financing round).
Suppose a startup called “TechInnovate” urgently needs € 100,000 to advance its product development. An investor called “VentureX” offers to provide this money as a convertible loan. In return for the loan, they agree on an interest rate of 5%.
One year later, TechInnovate is doing very well and is able to close a major financing round that values the company at € 1 million. Under the terms of the convertible loan agreement, VentureX can convert its 105,000 euros (loan amount plus interest) into shares and thus acquire a stake of approximately 10% in TechInnovate.
The financing dilemma
Convertible loans solve a problem that often arises in the early stages of a startup. In the beginning, startups usually have no (or little) recurring income to safely pay interest, and often have inadequate credit ratings. This makes obtaining a traditional loan from a conventional lender, such as a bank, difficult and costly.
At the same time, in the early stages of a startup, traditional financing by issuing new shares in the company is also fraught with difficulties:
- Valuing a startup in its early stages is usually difficult. In addition, it is often difficult to achieve a high valuation that is advantageous to the founders.
- Issuing new shares at a low valuation means that the founders may have to give up a large proportion of the company to investors already at the outset.
- Negotiating all the contractual terms of a financing round (including the investor’s shareholder rights) takes a lot of time and the transaction costs can be disproportionately high for a small investment amount.
Especially at a very early stage of the company’s history or between two financing rounds, the convertible loan can therefore be the ideal financing instrument from both the startup’s and the investor’s perspective. This is because the parties do not have to agree on a valuation or the terms of the equity investment (such as special shareholder rights) when concluding the convertible loan agreement. These are negotiated in a later financing round and then serve as the basis for converting the loan into shares in the company. In this way, the parties can defer the valuation and negotiation of the terms of the equity investment to a later date and possibly to other investors.
Advantages of a convertible loan
A convertible loan is therefore a cross between an equity investment and a conventional loan and offers the following advantages (depending on the structure of the contract).
Quick & simple
In contrast to a financing round, a convertible loan can be closed very quickly (even within a few days), as there is no need for lengthy discussions about the company’s valuation. This is a crucial advantage, especially for bridge financing (i.e. interim financing until the next financing round), which is why convertible loans are often used in such cases.
In addition to speed, a convertible loan is easier and less expensive to implement than a financing round. In contrast to the contractual documentation of a financing round, which can easily run to 50 pages including the investment and shareholder agreement, convertible loan agreements are often no longer than a few pages.
Convertible loans also offer great flexibility to startups and investors. The typical provisions of a convertible loan agreement are not subject to a mandatory legal regime, but are freely negotiable and thus offer the possibility of individual arrangements.
An investor granting a convertible loan is not a shareholder until the loan is converted and therefore has no shareholder rights. Convertible loan agreements often contain provisions on information rights. As a rule, however, the investor is not involved in the company’s decision-making processes. In individual cases, more or less far-reaching control rights are also possible, such as an obligation to approve certain management actions. The latter varies greatly depending on the specific contract.
Convertible loans are a promising financing option for startups. They offer flexibility and the ability to avoid early dilution. It is important to understand the specifics of this financing option and to have clear agreements. In the right context, convertible loans can be a useful addition to traditional financing rounds and support the growth path of startups.
If you would like to know more about convertible loans, read our second part of the blog series on convertible loans and learn all about the conversion process and typical provisions such as interest rate, discount and cap valuation.
Feel free to contact us if you have any questions about convertible loans or if you would like assistance in drafting a convertible loan agreement.