Convertible Loan

What is a convertible loan?

Convertible loan (German: Wandeldarlehen) denotes a loan to a corporation that, on the occurrence of a contractually defined event, is not repaid but converted into shares of the company. The contract is called a convertible loan agreement (CLA); in the US market, the convertible note corresponds to it. For the loan amount and usually the interest as well, the lender receives new shares at a price that the contract fixes or derives from the next funding round. Economically, it is a loan with a built-in right of exchange.

German startups and growth companies use the convertible loan to raise capital without already committing to a valuation, that is, a price for the shares. It serves in the early stage, as an interim round (bridge round) between two equity rounds and in follow-on financings by existing shareholders. Besides the company and the lenders, the existing shareholders are involved, who must approve the capital increase on conversion.

How it works and conversion events

Until conversion, the convertible loan is a loan within the meaning of Section 488 of the German Civil Code (BGB). The lender is a creditor, not a shareholder: the lender has neither a voting right nor a profit entitlement, but only the contractual rights.

What becomes of the loan is determined by the conversion events (conversion triggers):

• Qualified financing round: an equity round that meets the agreed minimum conditions, above all a minimum volume of new capital (qualified financing round). It is the normal case.
• End of term: If no such round comes about by the due date (maturity date), the agreed fallback rule applies: repayment, conversion or extension.
• Company sale: If the majority of the shares are sold before conversion (change of control), the lender usually has the choice between repayment with a premium and conversion immediately before closing.

The contract also fixes whether the lender may convert (conversion right) or must convert (conversion obligation). For the qualified round, the obligation is widespread.

Conversion price: interest, discount and valuation cap

Three quantities remunerate the risk of investing early, and a fourth sets the time frame:

• Interest: usually in the mid single-digit percentage range. Because it is converted along with the principal, it increases the number of conversion shares instead of draining liquidity.
• Conversion discount: a reduction on the price per share that the investors in the round pay, often between 10 and 25%, frequently 20%.
• Valuation cap (upper limit on valuation): the highest valuation at which conversion takes place. It secures the lender a minimum share if the round is valued highly.
• Term: in practice often 12 to 24 months.

Discount and cap do not apply side by side: conversion takes place at the lower of the two prices. The cap price is the valuation cap divided by the contractually fixed number of shares before the round.

Formula: conversion shares = (loan amount + accrued interest) / conversion price; conversion price = lower of round price × (1 minus discount) and valuation cap / shares before the round

Implementing conversion in a GmbH

New shares come into being in a GmbH (German limited liability company) only through a capital increase. The shareholders' meeting resolves it with three quarters of the votes cast in notarial form (Section 53 of the German Limited Liability Companies Act, GmbHG). The lender declares, in notarially recorded or certified form, that it takes over the new shares (declaration of acceptance, Section 55(1) GmbHG). The increase takes effect on entry in the commercial register.

There are two routes for the contribution. Either the lender contributes its claim as a contribution in kind, that is, as an asset instead of cash. The claim must then be worth at least the nominal amount of the new shares (usually EUR 1 per share), which the register court can examine; in a strained situation this is not certain. The second route is therefore widespread: the lender pays the nominal amount in cash and contributes the claim as an additional payment into the capital reserve, the equity above the share capital.

Because conversion depends on the shareholders, they undertake in the contract to approve the capital increase and to waive their subscription right. The subscription right is the right to take up new shares in proportion to the existing shareholding. If the contract provides for the assignment of existing shares, it must be notarially recorded under Section 15(4) GmbHG.

Subordination, Rangrücktritt and over-indebtedness

Until conversion, the loan is a liability that counts in assessing the duty to file for insolvency. Over-indebtedness exists under Section 19(2) of the German Insolvency Code (InsO) where assets no longer cover existing liabilities. This does not apply if continuation of the business in the next twelve months is predominantly likely.

If the lender is already a shareholder, its loan is subordinated by law in insolvency proceedings and is satisfied only after ordinary creditors (Section 39(1) no. 5 InsO). An exception applies, among other cases, to shareholders without a managing director role who hold no more than 10% of the share capital (Section 39(5) InsO). For the over-indebtedness test, this statutory subordination is not sufficient, and lenders who are not shareholders it does not cover at all.

This gap is closed by the qualified subordination agreement (qualifizierter Rangrücktritt): the lender contractually ranks even behind the claims under Section 39(1) nos. 1 to 5 InsO (Section 39(2) InsO). Such loans remain out of account in the over-indebtedness balance sheet, the comparison of assets and debts (Section 19(2) sentence 2 InsO, for non-shareholders by the widespread view applied accordingly). According to the case law of the Federal Court of Justice (Bundesgerichtshof), the subordination must already apply before insolvency: as long as and to the extent that payment would cause illiquidity or over-indebtedness, no payment may be made. The subordination also counts under supervisory law: if a company takes up repayable loans from many private individuals without it, a deposit-taking business requiring authorisation under the German Banking Act (Kreditwesengesetz) may exist.

Tax treatment of the convertible loan

For tax purposes, the convertible loan counts as an ordinary loan until conversion. At the company, the interest is a business expense; for trade tax, a quarter of it is added back to the extent that all add-backs together exceed EUR 200,000 (Section 8 no. 1 of the German Trade Tax Act, GewStG). For a private lender, the interest is income from capital assets, in principle subject to 25% flat-rate withholding tax. If the lender holds at least 10% of the shares, the personal tax rate applies (Section 32d(2) no. 1 of the German Income Tax Act, EStG). Interest converted along with the principal is as a rule deemed received on conversion.

The wording of the subordination agreement also has tax consequences. If the loan may be serviced only out of future profits or a liquidation surplus, the liability can fall away in the tax balance sheet (Section 5(2a) EStG). Taxable income then arises. It is therefore usual to add that payment may also be made out of other free assets. If the claim is no longer fully recoverable on conversion, taxable income can likewise arise at the company in the amount of the non-recoverable part.

Convertible loans in funding rounds and due diligence

Investors in the next round expect all outstanding convertible loans to convert with the round. They include the conversion shares in the cap table, the overview of all shareholders and their shares, usually in the number of shares before the round. The dilution from discount and cap is then borne by the existing shareholders. Whether the liquidation preference of the conversion shares, their priority in the distribution of sale proceeds, is measured by the conversion amount or by the round price is negotiated with the round.

In a down round, that is, at a lower price per share than in the previous round, the discount applies to this price. Without a valuation floor, more conversion shares then arise. Due diligence examines, for each contract, subordination, form, shareholder approvals, conversion parameters and rights of termination.

Worked example: calculating the conversion shares of a convertible loan

A GmbH has 90,000 shares with a nominal amount of EUR 1 each and 10,000 virtual shares from the employee programme, 100,000 shares together on a fully diluted basis. Business angels grant a convertible loan of EUR 500,000 at 4% annual interest without compounding and a 20% conversion discount. The valuation cap is EUR 8 million before the round, based on these 100,000 shares. After 24 months, a qualified funding round comes about.

• Interest: EUR 500,000 × 4% × 2 years = EUR 40,000; conversion amount: 500,000 + 40,000 = EUR 540,000
• Cap price: EUR 8,000,000 / 100,000 shares = EUR 80 per share
• Case A, round price EUR 125: discount price 125 × 0.8 = EUR 100; the lower value applies, that is, EUR 80
• Conversion shares in case A: EUR 540,000 / EUR 80 = 6,750; with the discount alone it would be 540,000 / 100 = 5,400, so the cap brings 1,350 shares more
• Value of the conversion shares at the round price: 6,750 × EUR 125 = EUR 843,750; the lender effectively pays 80 / 125 = 64% of the round price
• The lender's share in case A before the new capital of the round: 6,750 / 106,750 = around 6.3%
• Case B, round price EUR 90: discount price 90 × 0.8 = EUR 72, so below EUR 80; conversion shares: 540,000 / 72 = 7,500

The cap matters only in case A, because it applies only at a round price above 80 / 0.8 = EUR 100. Above that, the number of conversion shares stays at 6,750, and every further increase in value of these shares belongs to the lender.

Distinctions: convertible loan, SAFE and convertible bond

• SAFE: a US contract on future shares without interest or term, with money back only on a sale or dissolution before the round. For a German GmbH, usually modelled as a convertible loan.
• Convertible bond (Wandelschuldverschreibung): the instrument of the stock corporation under Section 221 of the German Stock Corporation Act (AktG), usually securitised and tradable and tied to a resolution of the general meeting. The convertible loan is an individual contract.
• Venture debt: debt capital that bears interest and is repaid on an ongoing basis, often with warrants over shares. The loan amount itself is not converted.

Common mistakes

• No qualified subordination agreement. The loan then counts as a liability in the over-indebtedness balance sheet and can contribute to the duty to file for insolvency.
• Shareholder cooperation not regulated. If the promise to approve the capital increase is missing, conversion depends on approvals that cannot later be enforced.
• Unclear reference base for the cap. Without a definition of which shares, pools and convertible instruments count towards the number of shares before the round, the cap price can be calculated in different ways.
• Template adopted without review. Freely available templates follow a particular structure; form, subordination, reference base and shareholder promises must fit the specific GmbH.

Frequently asked questions

Does a convertible loan have to be notarised?

Not in every case. The capital increase resolution with which conversion is carried out is always notarised. Because it is disputed whether even the shareholders' promises of cooperation require form, many convertible loan agreements are notarised as a precaution.

How is a convertible loan accounted for and booked?

As a liability, not as equity, even with a subordination agreement. The company books the payout against a loan liability and the accrued interest as interest expense against a liability. When the capital increase is entered, the liability is derecognised; the counter-value appears as subscribed capital and capital reserve.

Until then, the investor accounts for a receivable, in the case of longer-term investment usually as a loan under financial assets, afterwards a participating interest.

What happens if the next funding round does not materialise?

Then the rule on the end of the term applies, depending on the contract repayment with interest, conversion at a valuation agreed in advance or extension. If mandatory conversion has been agreed, repayment is not on the table at the due date.

Can several convertible loans exist on different terms?

Yes. Each loan is a separate contract and is converted individually in the round. New investors therefore demand a complete overview and sometimes harmonisation before closing.

The Roemer Capital view

When preparing a funding round, we request existing convertible loans first. For each contract, we record amount, interest accrual, discount, cap, term and conversion events. We calculate the conversion shares for several possible round prices before investors are approached. That way, the dilution is part of the company's own presentation before an investor's review uncovers it.

For a new convertible loan as a bridge, we make sure that the term covers the usual 6 to 8 months of a funding round with a reserve. The definition of the qualified round must fit the planned round structure. Subordination, form and contract text are the responsibility of the company's law firm.