A convertible loan is a financing instrument whereby investors initially provide a start-up with capital in the form of a loan. Under pre-agreed terms, the outstanding loan amount can later be converted into shares in the company.
The conversion often takes place during a future round of funding. This means that the company’s valuation does not necessarily have to be finalised at the time the loan is granted.
A convertible loan therefore combines elements of both debt and equity:
| Phase | Classification |
| Before the transformation | Investors are, in principle, entitled to repayment of the loan. |
| After the consecration | The loan receivable is converted, in whole or in part, into shares in the company. |
Typical features of a convertible loan are:
- Loan amount
- Duration
- Interest rate
- The timing and trigger of the transformation
- Valuation cap
- Discount on the next company valuation
- Repayment arrangements
- Treatment in the event of a business sale
- Investors’ rights
- possible obligation or option to rescind the contract
A common trigger is what is known as a substantial funding round. If the start-up raises new equity capital from an agreed minimum amount, the convertible loan is converted into shares in accordance with the specified terms.
What role do the discount and valuation cap play?
Investors often provide their capital at an early and particularly high-risk stage. In return, they may secure more favourable terms when the investment is subsequently converted.
| Regulation | Meaning |
| Discount | Investors will receive a discount on the share price in the next funding round. |
| Valuation Cap | The conversion is subject to a pre-determined valuation of the company at most. |
| Interest | Accrued interest may also be converted into shares, depending on the terms of the agreement. |
A simplified example:
An investor provides a start-up with 200,000 euros in the form of a convertible loan. In the next round of funding, a pre-money valuation of five million euros is agreed. The convertible loan carries a 20 per cent discount.
A correspondingly reduced share price is therefore used as the basis for the conversion. Early investors receive more shares for the capital they have invested than new investors in the funding round.
Which provision actually applies depends on the specific contract. If there is both a discount and a valuation cap, the calculation basis that is more favourable to the investors is often used.
What are the advantages of a convertible loan?
For start-ups, a convertible loan can offer the following advantages:
- relatively rapid raising of capital
- The business valuation may be postponed to a later date
- often involves less negotiation than a direct investment round
- Financial runway can be extended in the short term
- Preparations for a larger funding round are made easier
- flexible structuring of the conversion conditions
The model can also be attractive to investors:
- Early involvement in a fast-growing start-up
- possible discount or valuation cap
- Opportunity to share in any future increase in value
- initial loan entitlement
- clearly defined transition events
What are the risks and drawbacks?
A convertible loan is not automatically straightforward or risk-free. Potential challenges include:
- Unclear future ownership stakes
- Dilution of the existing shareholders’ stakes
- a heavy burden due to several convertible loans
- Disputes over valuation, discount or valuation cap
- Risk of non-repayment if no funding round takes place
- additional liquidity requirements upon maturity
- A more complex cap table following the conversion
- legal and tax requirements
It is particularly important for start-ups to calculate the impact on their future equity structure. Multiple convertible loans with different caps, discounts and interest rates can lead to greater dilution in the next funding round than initially expected.
What happens if there is no funding round?
The contract should clearly set out what happens at the end of the term. Possible options include:
- Repayment of the loan, including interest
- Extension of the term
- voluntary conversion
- mandatory conversion at a specified valuation
- Individual renegotiation between a start-up and investors
A common mistake is to focus solely on raising capital quickly. Before finalising the deal, founders should check what equity stakes would result from different valuations and whether any potential repayment would be financially viable.
innoWerft helps founders to structure their capital requirements, assess convertible loans and other financing instruments, and better understand their impact on valuation, the cap table and future funding rounds. It also supports start-ups in preparing for meetings with potential investors. The specific contractual, legal and tax arrangements should be reviewed by qualified legal and tax advisers.