Qualified Financing Round

What is a qualified financing round?

Qualified financing round (German: qualifizierte Finanzierungsrunde) describes an equity round that meets the minimum requirements of a convertible loan or other convertible instrument and therefore triggers its conversion into shares. In English contracts it is usually called a qualified financing or qualified equity financing. An equity round means that investors receive new shares in return for money. The most important feature is almost always a minimum volume of new equity, often supplemented by requirements on the type of contribution and the group of investors.

The definition is set out in the contract for a convertible loan. Among the conversion events (Conversion Trigger) it is the normal case, alongside the end of the term, a sale and an IPO. Those affected are the company and its founders, the lenders and, indirectly, the investors of the new round, in whose participation agreement the conversion is implemented. In practice, the qualified round is often the Series A. The US SAFE, by contrast, usually dispenses with a minimum volume; there, any round with a fixed price per share that serves to raise capital suffices.

Features of a qualified financing round

• Minimum volume: a fixed amount or a multiple of the loan amount. It must be regulated whether the amounts to be converted count and whether committed or actually paid-in funds count, for example in the case of payments in instalments (tranches).
• Type of financing: a capital increase against contributions. Loans including venture debt, grants and employee participations generally do not count.
• Type of contribution: in German rounds, investors often take new shares at the nominal amount, usually EUR 1 per share. They make the largest part of their investment as an additional payment into the capital reserves, the equity above the share capital. The definition must therefore refer to the total investment, not to the contribution to the share capital.
• Group of investors: whether new investors must participate or whether a round of the existing investors alone suffices.
• Timing: whether the signing of the participation agreement, the capital increase resolution or the registration is decisive. Since the conversion is usually carried out in the same capital increase, it must be clear no later than at the time of the resolution that the round qualifies.

Minimum volume: the level of the threshold

The threshold is meant to ensure that the conversion price comes from a round of relevant size in which a price was actually negotiated. Without it, a small follow-up financing by individual shareholders at a low price could set the conversion price for all loans, although this price has hardly been tested in the market.

If the threshold is too high, conversion does not take place even though a usable round comes about. The loan continues, interest accrues, and the new investors demand an agreement with the lenders before they come in. If it is too low, a small round with a hardly reliable price can trigger the conversion. In practice, the threshold is therefore often set below the planned round size, so that a smaller round than hoped for also suffices, and combined with a conversion right for non-qualified rounds.

Consequences for the convertible loan

If the round meets the definition, the loan is generally to be converted (mandatory conversion). The conversion price is the lower of the round price less the discount and the cap price (Valuation Cap). Conversion is into the share class of the new investors or into a class determined by contract. The conversion is implemented with the capital increase of the round and becomes effective on registration.

If the round does not meet the definition, the loan continues until the end of its term (Maturity Date), unless the contract provides a conversion right. Many contracts permit conversion also in a non-qualified round, at the request of the individual lender or by resolution of a majority of the lenders. If both are missing, only an amendment agreement with all parties remains.

The qualified round in the term sheet and due diligence

Investors of a new round check in due diligence whether their round qualifies for every outstanding convertible loan. Because they expect a capital structure without open loans, they often make the conversion of all instruments a condition to closing, without which the round is not completed. If the definitions of different contracts differ, the same round can be qualified for one lender and not for another. This can be seen as early as when reconciling with the term sheet.

Worked example: checking the threshold of the qualified financing round

Before the next round, a GmbH has 50,000 shares on a fully diluted basis, that is, including the shares from the employee programme. A convertible loan is outstanding, amounting to EUR 600,000 including interest, with a 20% discount and a valuation cap of EUR 10 million before the round on this number of shares. A round with at least EUR 2 million of new equity qualifies. Two possible next rounds are compared. The first is a follow-up financing by an existing investor of EUR 300,000 at EUR 120 per share, that is, a valuation of 120 × 50,000 = EUR 6 million. The second is a Series A of EUR 3 million at EUR 240 per share, that is, EUR 12 million.

• Cap price: EUR 10,000,000 / 50,000 = EUR 200
• Assuming the follow-up financing triggered conversion: discount price 120 × 0.8 = EUR 96, lower than EUR 200; conversion shares 600,000 / 96 = 6,250
• New shares of the existing investor: 300,000 / 120 = 2,500; lender's stake afterwards: 6,250 / (50,000 + 2,500 + 6,250) = 6,250 / 58,750 = around 10.64%
• Series A: discount price 240 × 0.8 = EUR 192, lower than EUR 200; conversion shares 600,000 / 192 = 3,125
• New shares of the lead investor, who leads the round: 3,000,000 / 240 = 12,500; lender's stake afterwards: 3,125 / (50,000 + 12,500 + 3,125) = 3,125 / 65,625 = around 4.76%
• Assessment: the follow-up financing stays below EUR 2 million and triggers no conversion, the Series A exceeds the threshold

Without a threshold, the small round with its hardly tested price would have triggered the conversion. The lender would have received twice as many shares, 6,250 instead of 3,125, and the founders would have given up correspondingly more. Conversely, the example shows why a threshold that is too high does harm: if it were at EUR 4 million, the Series A too would stay below it, and the loan would continue.

Distinctions: qualified financing round, conversion trigger, Series A

• Conversion trigger: the umbrella term for all events that trigger a conversion. The qualified round is one of them.
• Series A: a financing stage, not a contractual definition. It is often, but not necessarily, the qualified round of an earlier convertible loan.
• Bridge Round: an interim round that itself usually runs through convertible loans and, as a rule, is precisely not a qualified round.
• Capital increase: the company law procedure with which every equity round of a GmbH is implemented. Whether it qualifies is decided solely by the definition in the convertible instrument.

Common mistakes

• Threshold aligned with the target size. Anyone who sets the threshold at the targeted round size risks that a slightly smaller round does not qualify.
• Share capital instead of total investment. If the definition refers to the contribution to the share capital, even a large round does not reach the threshold, because most of it flows as an additional payment into the capital reserves.
• US terms in the definition. If the contract requires the issue of preferred shares, it does not fit a GmbH, which issues shares with preferential rights, without interpretation.
• Crediting unclear. Without a rule on whether converted amounts, tranches and existing investors count, it can become disputed whether the round qualifies.
• No route for non-qualified rounds. If a conversion right and majority decision are missing, a smaller round leaves only renegotiation with each individual lender.
• Inconsistent definitions. Several contracts with different thresholds mean that a round converts only some of the loans.

Frequently asked questions

How high is the minimum volume of a qualified financing round?

There is no fixed market size. Contracts name a fixed amount or a multiple of the loan sum. As a rule of thumb, the threshold lies noticeably below the planned round size, so that a smaller round than hoped for also suffices, but above the amount that individual existing investors would top up alone.

Does venture debt count towards the qualified round?

As a rule, no. The definition usually requires new equity from a capital increase; loans and further convertible loans count only if the contract expressly provides so.

Can a round with only existing investors be qualified?

That depends on the definition. Some contracts require the participation of at least one new investor, others let any capital increase from the minimum volume suffice.

Do grants count?

Not without an express provision. Subsidies and promotional loans are not equity from a capital increase and do not increase the round volume within the meaning of the definition.

When exactly does the loan convert?

With the capital increase of the qualified round. The conversion is resolved together with the round, and the new shares take effect on entry in the commercial register.

The Roemer Capital view

Roemer Capital reconciles the definition of the qualified round early with the term sheet of the planned round: minimum volume, type of contribution, group of investors and the decisive point in time. If a definition does not fit, this should be established before the participation documents are signed, so that the company's law firm can prepare amendment agreements with the lenders in good time.

In a process of 6 to 8 months, the final round size is often fixed only late. A threshold that reflects only the target size is therefore, in the view of Roemer Capital, an avoidable risk, which it addresses in the planning of the round.