For early-stage companies and start-ups in Germany, obtaining a traditional loan often requires a detailed company valuation—something not always feasible during the initial growth phases. Yet, access to capital is critical for these companies seeking to break into the market successfully. A convertible loan offers a unique solution: it provides quick liquidity without the immediate need for a full valuation by granting investors the option to convert the loan into equity in the future.
At Schlun & Elseven Rechtsanwälte, we specialise in guiding international entrepreneurs and businesses through the complexities of corporate financing in Germany. As a full-service law firm, we provide comprehensive legal support tailored to your needs, ensuring that every aspect of your financing is legally secure and aligned with your business goals.
Convertible Loans: A Smart Financing Option for Start-Ups in Germany
A convertible loan, also known as a convertible note, combines the characteristics of a traditional loan with the option to convert that loan into equity capital later. It initially functions classically as debt capital from the lender. The lender provides the company with the agreed sum of money as an investor or venture capitalist. Instead of the contractual obligation of a fixed repayment amount at a fixed time, the contract for the convertible loan contains an option or obligation to convert the loan amount into shares in the company. This conversion usually takes place at a later date, similar to the classic repayment agreement. This point in time is either a point in the calendar or is measured by agreed corporate milestones.
The primary advantage of a convertible loan in Germany is the simplified company valuation and risk analysis. This enables companies to obtain start-up or bridge capital even though they would not be eligible for a classic loan. The company generally needs a complete business plan with a multi-year forecast for a comprehensive company valuation. The possibility of participating in the company makes investing in this form extremely attractive for lenders despite the need for a meaningful company analysis. The convertible loan grants investors the right to convert the loan into equity in the company at a reduced price, depending on the agreement, so that potentially increased returns are possible for them.
In addition to the advantage of receiving start-up or bridge capital when the company has been rejected for traditional loans, the convertible loan in Germany can also be an attractive option in other respects. The particular form of the loan agreement offers maximum flexibility for the borrowing company. Initially, the loan is used purely as debt capital and depending on the contract, the company can make the lender a shareholder or traditionally repay the loan.
In Germany, the conversion of the loan into equity capital usually takes place through a capital increase that forms part of the company’s financing. The company’s shareholders decide to create new share capital by issuing additional shares. The lender then takes over these new shares. The exact number of shares that the investor receives during the conversion is based on the calculation formula agreed upon in the convertible loan agreement. This formula usually considers a valuation discount relating to the next financing round.
Drafting Contracts for Convertible Loans in Germany: Key Considerations
The versatility of convertible loans in Germany demands careful planning and contract drafting. Each agreement should be customised to meet the specific needs of the business and investor, with particular attention given to the terms governing the conversion of the loan into equity. The cornerstone of the agreement is deciding whether conversion will be optional or obligatory. The following elements must also be clearly defined in the contract:
- Conversion Rate: The conversion rate determines how the loan will convert into shares. Typically, it is set below the future share price, offering the lender a favourable conversion rate as an incentive.
- Discount: A discount on the share price at conversion is often included to reward investors for the risks of early-stage investment. This discount can either complement the conversion rate or be structured as a particularly advantageous conversion price.
- Interest Rate: Although the loan is generally intended to convert into equity, it may accrue interest until the conversion occurs. This provides additional security for the lender while awaiting conversion.
- Conversion Events: Conversion is usually tied to specific triggers, such as:
- A new round of financing.
- The sale of the company.
- Achieving key performance indicators.
- While a calendar date can be used as a trigger, it carries risks for borrowers, particularly if milestones are delayed.
- Investor Rights: Investors may negotiate specific rights, including:
- Information and consent rights on key management decisions,
- Anti-dilution protections to safeguard their equity,
- Preferential terms for exit proceeds or liquidation events,
- Equal or better treatment clauses compared to future investors.
- Loan Amount and Other Standard Terms: Fundamental loan terms, such as the principal amount and repayment conditions, must also be carefully articulated to ensure clarity and legal compliance.
Convertible loan agreements must balance the flexibility companies need with the protections investors seek. Poorly drafted agreements can lead to disputes or unfavourable outcomes, particularly regarding equity dilution or conversion timing.
At Schlun & Elseven Rechtsanwälte, our German corporate lawyers draft convertible loan agreements to match the needs of international businesses and start-ups in Germany. We ensure the contract details comply with legal requirements and support your business goals.
Providers of Convertible Loans in Germany
Convertible loans in Germany are exclusively provided by venture capitalists rather than traditional credit institutions, despite the term “loan” suggesting otherwise. Typically, these loans come from investors who already hold a stake in the company and are looking to expand their investment. However, third-party investors—who may not have an existing relationship with the business—can also provide convertible loans, offering additional opportunities for external funding. This financing model is particularly attractive to venture capitalists due to its hybrid nature, blending debt security with the potential for equity ownership in the future. For businesses, it represents a flexible way to secure capital while fostering valuable investor relationships.
Practice Group: German Corporate Law
Practice Group:
German Corporate Law
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