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A. The Loan Elements
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1. Parties
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- There are two kinds of CLAs:
- Bilateral – CLAs concluded solely between the borrower (startup) and the lender.
- Multilateral – CLAs to which the borrower, lender and shareholders of the borrower become parties. For reasons explained below, we prefer multilateral CLAs.
- Shareholders should take steps to allow for a conversion into equity (if time comes). They can do that in the CLA itself or, in case of a bilateral CLA, by concluding a separate agreement in the form of a genuine contract for the benefit of third parties (echter Vertrag zu Gunsten Dritter) outside the CLA.
- They also should ensure that any third parties becoming shareholders of the startup also assume cooperation obligations pursuant to the CLA (in particular, with regard to implementing the conversion).
- In a bilateral agreement, the lender also might want to request a notarized authorization resolution of the borrower's shareholders' meeting (see below for more details on form requirements).
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2. Purpose and Utilization of the Loan
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- Some investors might ask for specifications and limitations for using the loan amount. Try to be as specific as needed but leave room for maneuvering to obtain operational freedom for management. It will often suffice to make sure that the loan amount will not be used to repay shareholders.
- Sometimes investors want to pay out the loan amount in tranches at certain milestones. We are generally not a fan of this approach as circumstances and the startup's environment change too fast. Against this backdrop, word any references to milestones in such a way that they can be objectively verified and do not deprive the borrower of flexibility in developing the business.
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3. Interest
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- The loan amount usually bears interest, though we sometimes see short-term (bridge) loans where interest accrues only when the loan is not converted in a qualified financing round within a short period after the loan is disbursed, usually three to six months.
- The CLA should set forth the interest rate, calculation method and, as the case may be, provisions regarding capitalizing interest.
- In the current market, we frequently see interest rates between 7% to 10% p.a. While rates came somewhat down in recent years, given the relatively wide availability of early-stage financing in many sectors, starting in early 2022 we saw an uptick in rates. For internal bridge financings, though, interest rates tend to be lower. For (later-stage) convertibles, interest rates occasionally go up after a time unless the loan is converted into equity.
- In the United States, so-called SAFEs are more common than classical convertible notes in early-stage financing (SAFEs have no interest rates). Yet convertible notes are still responsible for a significant chunk of the overall funding market. According to data from Carta and other service providers, an average of 8% has become standard across early stages.
- Note that from an economic (dilution) perspective the discount, and particularly the cap on the conversion price (if any), are usually more important than the interest rate – so, as a founder, choose your battles wisely.
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4. Term
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- Is the term appropriate considering the purpose of the loan?
- In pure bridge financings ahead of an equity financing, the term of a CLA is often six months. In other cases, it is usually 12 to 24 months, rarely longer.
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5. Subordination
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- The CLA must contain a properly worded qualified subordination clause (to avoid cases of insolvency).
- It is important to ensure a subordination clause does not unintentionally qualify as a waiver and trigger negative tax consequences.
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B. The Conversion Elements
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Convertible loans are "loans to own". They are not meant to be repaid but are usually meant to be converted into equity in the future. Consider:
- When can or must the loan be converted? These events are the so-called conversion events.
- Who decides about the conversion? Is it only the lender's right or also an obligation?
- How many shares will the lender get? This question depends on the so-called conversion amount and the applicable conversion price.
Let's look at each of these items in more detail.
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1. Conversion Event
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- The CLA should specify when the lender is entitled or obliged to convert the loan.
- Typical conversion events include:
- The next (qualified) financing round.
- The expiration of the CLA term (a "maturity date conversion").
- The standard conversion event is the qualified financing round. A qualified financing round usually requires a minimum investment amount. Sometimes a minimum pre-money valuation for the round is stipulated as well. The CLA should define the requirements of a qualified financing round. This particularly includes, for example, whether the round must also include new investors and that only "fresh money" will be considered when determining the size of the financing round (i.e., not the loan amount(s) that will be converted in.
- What if the startup or its business gets sold before the loan is converted? Sometimes, an exit before the end of the CLA term is also considered a conversion event. In such a case, however, to avoid further complexity, the parties should consider if they should simply entitle the lender to a one-off compensation claim against the borrower in lieu of a conversion of the loan into shares (which would then need to be sold to the acquirer immediately). Spoiler alert – this might have differing tax consequences (see below).
- Exit kicker payments frequently amount to 1–2x of the outstanding principal. And accrued interest comes on top of the repayment of the loan in case of an exit. Note that any cash payment claim exceeding the principal amount will subject the lender to the same German taxation as its interest claims, i.e., a higher tax rate compared to a situation where the lender would, prior to the exit, convert its claims into shares and sell those shares in the exit.
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2. Conversion Right or Obligation?
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Who should be entitled to request a conversion of the loan upon a respective conversion event? The company? The lender? Both?
- On one hand, it is common to grant the lender the right to request a conversion into equity in a subsequent financing round. Remember, the mezzanine character and economic value of the lender's commitment is not per se associated with interest on its repayment claim (distinguishing this from venture debt loans) but with the conversion element.
- On the other hand, the borrowing company also has an interest in being able to demand a conversion of the repayment claim (including any accrued interest) to avoid jeopardizing further financing options and keeping the startup's debt-side "clean." Likewise, investors in future financing rounds will generally insist on a (timely) conversion as the convertible loan is, in this respect, a structurally prioritized debt instrument. In addition to the risk of future dilution (if a conversion occurs later), investors would be exposed to the risk that their liquidation preferences regularly provided for in the shareholders' agreement could be undermined by senior ranking debt items on the balance sheet.
In practice, we often see combinations of conversion obligations and rights to accommodate individual interests of all stakeholders to the greatest extent possible.
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3. Number of New Shares
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- The CLA should specify which conversion amount may be converted at which price. This constitutes the basis for determining the number of new shares to be issued to the lender.
- For the conversion amount it is critical to know whether the loan amount accrues interest and, if so, whether the interest will be converted or paid in cash (converting accrued interest is standard), among other things.
- The conversion price usually differs according to the conversion event:
- For a conversion at the expiration of its term (maturity date conversion), the conversion price should be fixed when entering into the CLA.
- For a conversion in a (qualified) financing round, the conversion price is usually based on the pre-money valuation of the round, provided that usually a discount between 15% and 25% (often around 20%) is applied, and that the maximum valuation is capped. From an economic point of view, discounts and caps are risk premiums for providing capital in the early stages of the business.
- A discount is applied regardless of the valuation, while a cap only benefits the lender if the valuation of the round exceeds the cap.
- In relatively few cases, the parties agree on a minimum valuation (floor) to determine the conversion price. In practice, the pre- or post-money valuation of the last financing round is from time to time used as a floor for the convertible loan in case of a bridge financing by a convertible loan between two (equity) financing rounds.
- In cases where an exit (in particular sale of the borrower or the majority of its assets) happens prior to the expiration of the loan term, a conversion will be triggered, and the conversion price is often derived from the exit valuation minus a discount. However, as mentioned above, the CLA often will foresee a cash payment on top of the repayment of the loan in case of an exit rather than a conversion.
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4. Implementation of the Conversion
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- The executed in the form of a capital increase in cash against the issuance of new shares at par value (i.e., EUR 1 for shares with a nominal value of EUR 1).
- The repayment claim will be assigned and contributed into the borrower's capital reserve subject to registering the capital increase.
- Sometimes the CLA contains provisions obligating shareholders to implement the capital increase and waive their otherwise subscription rights (recommendable in multilateral agreements). In other cases, such provisions are provided for outside the CLA in a corresponding authorization resolution of the shareholders' meeting of the borrower.
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C. Some other Provisions
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1. Shareholders' Agreement and Pooling
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- Should a provision be included according to which the lender must accede to a shareholders' existing agreement, newly concluded or amended in the qualified financing round? (Attention: This may result in a notarization requirement with respect to the CLA, see below.)
- In case the borrower has taken out multiple (smaller) CLAs, it might be advisable to obligate the lenders to pool their (micro) shareholdings and to grant voting power to a pool leader.
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2. Other Provisions
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- If the lender is not a shareholder at the time the convertible loan is granted, we often see a request for extensive information rights and periodic reporting obligations of the company's management to be able to continuously assess the financial situation of the company.
- In addition, management may also be asked to submit a business plan for the following year at the end of each financial year and to inform the lender immediately of incidents that could cause a significant deterioration in the economic position of the company.
- In certain situations, particularly in granting significant loan amounts by key investors that are not yet shareholders of the borrower, we see requests for consent rights for specific actions and measures of the company, as is known from the shareholders' agreements in equity financing rounds.
- Every now and then, CLAs also contain provisions which grant the lender a consent right in case the borrower wishes to take out further convertible loans which would provide for more favorable conditions for the future lender (so-called most-favored nation clause).
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3. Form Requirements
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Let's come to the Achilles' Heel of convertible loans in Germany. Unfortunately, there is some legal uncertainty around the form requirements applicable to the CLA.
- The safest way is (and always has been) to notarize the CLA (beurkunden). While there are good arguments that a CLA structured as a multilateral agreement with no obligation to join a notarized shareholders' agreement does not require notarization, there is no decisive case law on this question yet.
- Nevertheless in the past, the market frequently chose multilateral agreements and avoided an obligation to accede to a notarized shareholders' agreement in the text of the CLA, executing the CLA in writing or text form such as DocuSign. This held true at least for CLAs with relatively modest loan volumes (less than a few million).
- However, according to a recent decision by a German higher regional court (OLG Zweibrücken) the signature by the lender requires notarial certification (Beglaubigung). While the decision has been widely criticized, for now at least, a notarial certification of the lender's signature seems advisable to reduce legal uncertainty.
- Otherwise, in a worst-case scenario, the CLA can be void with potentially severe consequences for the borrower and its managing directors. For example, without a valid subordination clause (Rangrücktritt), the lender's repayment claim (the "loaned" amount might be subject to immediate repayment) would need to be considered when testing whether or not the borrower is insolvent.
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