Knowledge – Convertible Loans & Equity Rounds – Do’s and Don’ts

When it comes to financing start-ups, questions arise about convertible loans or equity rounds. We shed light on this topic.

The starting point.

It’s common knowledge: startups need money. At times they need tons of money. And that’s why there is a need for financing.

Startup financing typically occurs in various rounds, traditionally categorized as pre-seed, seed, Series A, Series B, Series C, and beyond. The end goal is most cases is an acquisition or an IPO. During each of these rounds, companies raise capital by offering equity or taking on debt that can later be converted into equity.

This leads us to the two forms of financing that we would like to discuss in detail below: equity rounds and convertible loans.

An equity round means new shares are issued and sold to investors, resulting in the dilution of existing shareholders‘ equity. Here, a necessary pre-step involves setting a valuation for the respective company, which determines the price per share. And this process can be really though and may mean that you will have to fight hard with the new investors over the pre-money valuations, so the valuation before their investment.

A convertible loan on the other hand is a form of debt financing where investors lend money to the company. They do so because there is the agreement that the loan will convert into equity at a future financing round. Typically this happens at a discount compared to the share price in the financing round. This avoids the need to set a valuation at the time of funding. A convertible loan is effectively pegged to the valuation of the subsequent financing round.

The conversion of the loan into real shares, usually takes place in the context of a capital increase (so that means that the share capital gets increased). In this way, new shares are created, which are taken over by investors.

The shares are usually acquired at the nominal value of 1 EUR. The investor contributes the loan portion as a so called agio (surcharge).

Let’s now compare the main motives behind a convertible loan and an equity round.

 

 

Motives behind.

Convertible loans:

  • Fast: Convertible loans tend to be quicker to implement, as they involve fewer terms to negotiate. There’s no need for a public registration or detailed discussions around valuation, which speeds up the process.
  • Cost-efficient: The process of issuing a convertible loan is typically more affordable due to lower legal and administrative costs compared to an equity round. This makes it a more budget-friendly option for early-stage companies.
  • No need to define a valuation: One of the key advantages of a convertible loan is – as already mentioned – that it avoids the immediate need to establish a valuation for the company.
  • Notarization (TBD): It used to be assumed that convertible loans did not require notarization. However, according to a ruling by the German Higher Regional Court Zweibrücken in 2022, this is disputed in legal practice. We highly recommend notarization. Better safe than sorry.

Equity rounds:

  • Investors as new shareholders: In an equity round, investors immediately become shareholders in the company. This brings new equity partners into the business and allows them to have a say in company decisions, typically influencing governance.
  • Visible to the public: Equity rounds usually result in a more transparent process, with the new funding being publicly visible in the respective commercial register – Handelsregister. This can increase the company’s visibility and credibility in the market and with other potential investors.
  • Less vagueness: An equity round is often a more structured process, with detailed terms laid out in the officially notarized documents, including governance provisions, rights, and obligations of all parties involved. This reduces vagueness and offers clearer terms for both the company and its investors.

 

Let’s now look at a few dos and don’ts.

 

 

Convertible Loans – Do’s:

  • Clear Mechanism of Conversion: Ensure that the mechanism for conversion is clearly defined, whether it is flexible or fixed. The company should have the right to convert the loan into equity. This prevents any repayment obligations from arising and gives the company the flexibility to convert debt into equity at an appropriate time without the burden of having to repay the loan in cash. And to be honest, the vast majority of convertible loans are converted.
  • Precise Definition of „Equity Round“: Once again: the crucial point in time for Convertible Loans is a subsequent equity round. This event triggers the conversion and sets the conversion rate. So: Clearly define what constitutes an „equity round“. Defining this event helps avoiding vagueness and provides clarity for both current and future stakeholders.
  • Strong Subordination Clause: This clause means that the loan is legally treated as equity. The reason for this is insolvency law. If you forget to implement this clause, it can lead to your company being over-indebted on the balance sheet. This in turn triggers the obligation of the management to file for insolvency. And we definitely do want to avoid that.
  • Anticipate Your Cap Table Post-Conversion: Be sure to anticipate and plan for the impact of the conversion on your capitalization table (cap table). Knowing how the conversion will affect the ownership structure and the dilution of existing shareholders will help you manage expectations and prepare for the new equity distribution.
     

Convertible Loans – Dont’s:

  • Provide Extensive Business Guarantees: Avoid providing excessive business guarantees (such as promises regarding earnings, growth, or performance milestones). These kinds of guarantees can create significant liabilities and are difficult to define and predict, especially when the company is still in the early stages and there is uncertainty around its future performance.
  • Wrong Form May Lead to an Unenforceable Conversion Right: Ensure that the convertible loan agreement is correctly drafted and in the proper form – that means notarized. If the agreement is not drafted correctly, it may lead to an unenforceable conversion right, leaving both the company and the investors in a precarious situation with no clear path forward.
  • No/Unspecific Definition of Trigger Events: Once again: It’s essential to clearly define the trigger events that will initiate the conversion of the loan into equity. Vague or undefined trigger events can lead to confusion or disputes about when and how the conversion will occur, potentially compromise the relationship between the company and its investors.
  • Disregard of Applicable Law: Be sure to comply with all applicable laws, including corporate and securities regulations, when drafting and executing convertible loan agreements. Failure to adhere to legal requirements can result in unenforceable terms or legal complications that may harm the company’s prospects or even lead to regulatory issues. Better call pikepartners. 😉
     

We can also do the same for “classic” equity rounds. Here, there are do’s and don’ts, too.

Equity Rounds – Do’s:

  • Prepare a Proper and Thoughtful Cap Table: The first thing you need to do when structuring equity is to prepare a comprehensive and well-thought-out cap table. A captable outlines the ownership structure of the company, including how shares are distributed among founders, investors, and employees. A clear and accurate captable helps ensure transparency and avoids misunderstandings down the line. It’s crucial to think ahead and plan for future financing rounds, potential exits, and dilution scenarios.
  • Ensure the Governance Structure is Under Control: Governance is vital for the long-term health of any company. Having a governance structure that is clearly defined and well-managed is key. This includes knowing who has decision-making authority, how board meetings will be conducted, and what role each shareholder plays in the company’s operations. A well-structured governance system promotes stability and ensures that the company can navigate both opportunities and challenges effectively.
  • Maintain Clear Structuring (Milestones, Pooling, Closings): When it comes to the financial and operational structuring of equity rounds, clarity is crucial. This includes planning for things like multiple closings, setting specific milestones, and considering pooling arrangements. By having clear, organized structures in place, you can align investor expectations and create a smoother execution process, ultimately minimizing confusion and conflict.
  • Take Control of the Process and Execution:
    Equity deals can be complex, involving various legal and procedural steps, such as notarization and registration with the respective commercial register. It’s important to have control over the entire process—from drafting agreements to executing necessary actions. Also, make sure the timeline of these steps aligns with your company’s runway, as delays or misalignments can compromise your financing strategy and operations.

Equity Rounds – Dont’s:

  • Avoid Overcomplex Shareholders’ Agreements: While it might seem like a good idea to make a shareholder agreement (SHA) comprehensive and very detailed, an overly complex agreement can lead to confusion and even deadlocks. Too many terms and conditions can create friction among shareholders, making it difficult to make decisions or move the company forward. The best SHAs are simple, clear, and designed to facilitate smooth operations.
  • Do Not Provide Extensive Business Guarantees: This is basically the same as for Convertible Loans: Offering extensive business guarantees is dangerous and can create significant – even personal – liabilities. No one can predict the future with certainty, and such promises can come back to haunt you if your business does not meet those targets. It’s important to be realistic and cautious about any guarantees you make, and instead focus on creating a plan that is flexible and adaptable.
  • Underestimate the Importance of Minority Rights: Minority shareholders can have a significant impact on governance and company decision-making, so it’s crucial to carefully draft and consider their rights. A well-thought-out approach to minority rights will ensure that they are treated fairly, and that their interests are protected, without compromising the decision-making process of the majority.
  • Overly Optimistic Exit Scenarios: Finally, overly optimistic exit scenarios can cloud your judgment when planning for the future. Focusing too much on ideal exit opportunities can make it difficult to consider alternative scenarios, such as potential separations or changes in the market. It’s essential to take a balanced approach, taking into consideration both the opportunities and the risks in any business venture.
 
 

To conclude, when navigating the world of startup financing, whether through equity rounds or convertible loans, it’s essential to approach the process with clarity and careful planning – and a good lawyer by your side.

In an equity rounds, defining your cap table, governance structure, and terms with precision can set the foundation for long-term success, while also being mindful of potential pitfalls like overly complex agreements or unrealistic exit expectations.

Conversely, convertible loans offer flexibility, and cost-efficiency and are quite fast. However, they require clear mechanisms for conversion, well-defined trigger events, and legal compliance to avoid complications down the line.

By adhering to these key do’s and avoiding common don’ts, you can navigate the complexities of startup financing while ensuring that both your company and investors are aligned and protected.

 

 

Dr. Mathias Fromberger is a lawyer and partner with pikepartners. pikepartners. is a boutique law firm based in Munich.

Besides being a lawyer Mathias is a founder himself. He startet founding his first companies in school where he invented such things like the “Frühstuckomat” or “Das wachsame Lenkrad”.

After that, the areas in which he engaged in entrepreneurial activities are quite diverse: they range from automotive to fashion, real estate and legal tech.

These days, he passes on his experiences to founders. He does this, in part, as a lecturer at the Stuttgart Media University.

At pikepartners. we do have strong focus on advising start-ups and start-up investors in all phases of a start-up’s life cycle. We look forward to you getting in touch.

 

 

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