Convertible Loan Agreements - Legal And Tax Insights To Get It Right From The Start

• Published date: 05 April 2024
• Law Firm: Wenger Vieli AG
• Author: Mr Michael Baier, Patric Eggler, Kevin Vangehr, Michelle Wiki and Jonas Bühlmann

Convertible loans have long been a flexible and popular tool for investing in early-stage companies (start-ups). In this article, we explore how convertible loans work, highlight their advantages and disadvantages compared to equity financing, and address important considerations prior to executing a convertible loan agreement. We will clarify the complexities surrounding some of the key elements of convertible loan agreements, such as discounts, caps, the different conversion events and tax considerations. It should provide founders and investors with straight-forward guidance on this financing instrument by briefly outlining the key considerations to make informed decisions when choosing between convertible loans and equity financing.

1. What is a Convertible Loan?

A convertible loan is a financing instrument designed to quickly secure cash without the complexities of an equity financing round. An investor lends money to a start-up with the right (voluntary conversion) or obligation (mandatory conversion) to convert the loan into shares in the company if and when a conversion event occurs. The determination of whether the conversion is considered a right (voluntary conversion) or an obligation (mandatory conversion) from the investor's standpoint, as well as the identification of the corresponding conversion events, are stipulated in the convertible loan agreement and are subject to negotiation. A conversion event can be a defined maturity date, the occurrence of the next equity financing round or an exit transaction.

2. What is the Incentive for a Start-Up to Enter into a Convertible Loan Agreement with an Investor?

Equity financing is the prevailing investment choice for start-ups to obtain funds. For early-stage start-ups, determining the company's reasonable valuation is often a challenge. Early-stage start-ups often do not have paying customers, market traction, profits, or even revenue yet. This makes it difficult (if not impossible) to come up with a reasonable or fitting valuation of the company.

In the absence of a clear valuation, founders may agree on low valuations and thus accept a high dilution of their shareholdings in the company. The same can of course apply to investors in case the valuation is unreasonably high. Thus, choosing a convertible loan is advantageous if the start-up aims to delay detailed valuation discussions. It is still paramount that the start-up and the investor agree on specific conversion terms, which in most cases refer to the next (qualified) financing round, exit transaction and the maturity date of the loan.

In addition, convertible loans have proven helpful when there is not enough time for an equity financing round and/or when a start-up only needs to raise a small amount of funds, e.g. to bridge a few months of liquidity between equity financing rounds.

In conclusion, the primary incentives for start-ups (and investors) to enter into convertible loan agreements lie mainly in the avoidance of extensive negotiations and valuation discussions between the start-up and the investors as well as ensuring quick access to funds, which will be converted into equity in the near future.

3. Key Legal Terms in Convertible Loan Agreements

Convertible loan agreements are governed by precise legal and tax provisions that dictate the functionality of this financing tool. When entering into negotiations of a convertible loan agreement, it is crucial for both investors and start-ups to be familiar with the relevant terminology and to understand the consequences of certain terms and conditions.

3.1 Loan Amount and Interest Rate

The loan amount represents the funds granted to the start-up by the investor. The loan amount can vary greatly, typically between 25'000...