Convertible Note

Convertible loans occupy a hybrid position between equity capital and debt capital. After all negotiations have been concluded, a capital increase is decided by the shareholders of the company and the share capital is increased by the new proportionate amount, as in the case of financing with equity capital. The capital contribution is to be made directly to the company. The remainder flows to the company in the form of an interest-bearing convertible loan. The convertible loan is not necessarily based on a valuation, as is the case with a classic open participation. A valuation only becomes necessary as soon as the investor exercises his conversion right and acquires new shares at the price agreed in the financing round. The investor therefore has the right (sometimes the obligation) to convert his bond into shares at a predetermined price.

Discount and Cap

The special feature of start-up participations via convertible loans in contrast to traditional convertible loans is that, although investors benefit from an increase in the value of the company, they do not want an overvaluation of the company in the subsequent round because they receive fewer preference shares in the event of a conversion. One way to avoid this problem is to agree on a valuation cap, i.e. a limit on the maximum amount that can be used to determine the conversion price.

Example: Suppose an investor has a nominal loan amount of 1 million euros with a valuation cap of 8 million euros and accrued interest of 100,000 euros. The company’s pre-money value is EUR 10 million in Series A preferred shares at a price of EUR 10 per share. The agreed cap at €8 million now limits the valuation and the price per share the investor must pay to convert is below the price paid by the Series A investors. The price in this case is 8 euros. The investor with the convertible loan now receives 137,500 preferred shares instead of 110,000 shares ((1 million nominal value of the loan plus 100,000 Euro interest) / 10 Euro).

Alternatively, a discount on the new share price can also be agreed directly. Discounts of up to 30% are usual in the market.