Emerging companies and venture capital

Start-ups need funding for the development of their service or product and their ‘go to market’. Loans with banks and other commercial lenders are often not feasible at the early stage. However, a convertible loan from an investor or a group of investors may offer possibilities.

A convertible loan seems quick and easy to arrange: no extensive paperwork required and involvement of a civil law notary isn’t necessary (yet). Several template agreements are easily accessible online. At face value, the convertible loan appears the simplest and cheapest way of financing.

However, a convertible loan is not necessarily cheaper. Practice shows that the opposite might even be the case. Founders (and investors) misjudge the complexity and consequences of a CLA. Sooner or later a valuation is required and only then will founders know how much of their company they have given away. The same goes for investors, who won’t know what the value of their investment is until conversion. Conversion can lead to disappointment for founders and investors alike and some investors won’t enter into convertible loans at all for these reasons.

Moreover, as a founder, your freedom to lead your company will probably be limited in the interim and quite a few decisions will require the lender’s permission.

Each case or deal is different and working from a template might prove risky. Many templates found online are particularly investor-friendly. However, after reading this article, founders will know where the pitfalls lie so they may enter into negotiations well prepared.

After reading this article, you will know:

  • what a convertible loan (CLA) is,
  • what the advantages of a CLA can be,
  • what the key issues are, and
  • the most common clauses and terms of a CLA and what they mean.

Convertible loan (CLA): what is it?

A convertible loan or CLA provides a loan that can be converted into shares or depositary receipts of shares at a later date – at a conversion event or trigger event. When the loan is converted into shares at such a conversion event, the company issues shares (or depositary receipts of shares) to the lender, which settles the consideration for them against its loan plus accrued and unpaid interest.

The trigger events thus determine when the convertible loan is converted into shares. Reaching the maturity date of the loan is often one of those conversion events: at the end of the duration of the loan agreement, the loan (often at discretion of the CLA holder) is either repayable or convertible into shares. Another trigger event is closing a Qualified financing or Next equity financing: if a new investment round closes during the duration of the CLA, the investor is allowed to convert at the same price and at equal terms as the investors in the new investment round, sometimes with a discount (on discounts, read more below). Finally, an Event of Default is often a trigger event. An Event of Default may occur, for example, if the company fails to comply with the terms of the CLA, is declared bankrupt, ceases its business activities or changes the nature of its business. Also, the departure of the Founder (in combination with a change of control clause) or departure of key personnel is sometimes included as an event of default or separate trigger event. Finally, a Liquidity event or Exit can also be included in the list of trigger events. A Liquidity event is often understood as a sale of the company.

There is not ‘one ultimate’ CLA template. CLA’s with conversion at maturity or at the time of a Qualified Financing at a valuation to be determined (or at the valuation at the Qualified Financing) are most common in practice. However, convertible loans that will always convert are becoming more popular, because they might convert at a predetermined price per share, whether or not in combination with a method to adjust the price in the interim (also called an Adjustment event). Also on the rise is the Fixed percentage convertible note: a convertible loan that upon conversion yields a fixed percentage of all shares in the company. A commonly known version of such an instrument is a SAFE.

Advantages of the convertible loan

A convertible loan is often seen as a solution to valuation issues in start-ups. Start-ups are inherently difficult to value because the value of the company is locked in its growth potential over time. An EBITDA multiple or a discounted cash flow valuation method will not adequately take into account the growth potential of the start-up. With a CLA, valuation may be postponed until such a time when the start-up has already established a financial track record and has a more robust growth trajectory. In most cases, it is also possible to tie in with the valuation of a future investor (with Qualified Financing).

For the investor, the CLA is also interesting from a tax perspective: if things go wrong and the start-up fails, the investor has to write off part of the loan, which write-offs are tax deductible for the investor. Until the moment of conversion, the investor qualifies as a regular creditor, which means payment before any shareholders in case of bankruptcy. Only after conversion, the lender becomes a shareholder (or holder of depositary receipts of shares).

Another advantage of the CLA is the speed with which it can be settled. With a CLA, parties can theoretically suffice with the standard provisions from the usual  loan agreement, such as the duration and the interest rate, supplemented with clauses on the conversion moment and the way in which the conversion will then take place. A trip to a civil law notary is not yet necessary (in the Netherlands, civil law notaries are the only legal professionals capable of issuing shares of a company). This also saves costs (for now). A shareholders’ agreement is also not yet necessary yet. Less negotiations, less governance issues.

But what about future costs? A CLA may seem cheap now, but appearances may deceive. With a convertible loan, costs are only pushed back and delaying until conversion. This is generally worth something to start-ups as well (cashflow and liquidity is king), but parties should be aware that conversion can be a costly affair. A civil law notary will be required, because shares will have to be issued, which requires a notarial deed. Valuation issues may then arise. In some cases a valuation by an independent expert is required. That valuation in turn determines what percentage of the company the investor gets and  the percentage the founder gave a way in hindsight. Especially when the CLA converts because of a Series A funding (next investment round), negotiations on shareholder rights and obligations versus founder rights and obligations will have to be done. Not to mention to get an agreement on the cap-table of the company after conversion.

It is important to think these things through before executing a CLA, and that brings me to the main items to consider when negotiating one.

Items to consider when negotiating a convertible loan

Start-up and scale-up founders and investors would do well to realize the following and include the following aspects in their negotiations:

  • A CLA is quick and easy, but don’t forget a few other documents are required. Pursuant to Dutch corporate law, a convertible loan legally qualifies as a ‘right to take shares’. As a consequence, co-shareholders must be notified of the CLA and preemptive rights may be triggered, if not excluded. A shareholder resolution is necessary (and in some cases a resolution of a supervisory board).
  • There are several templates accessible online that can get you started. Experience shows that these models might be quite investor-friendly. When using these templates, pay particular attention to the warranties and covenants; clauses that ensure that you as founder have less freedom to act and in some cases may require you to get prior consent of lenders (or a Lender Majority). For example, acquiring a relatively small amount of working capital might require prior approval.
  • Postponement of the valuation discussion, as mentioned above, is also not a reprieve: at the time of a subsequent investment round (Series A) or a conversion beyond qualified financing, parties will often still need to discuss the valuation and the method of conversion. If conversion can also take place without a subsequent investment round, make sure to agree on a valuation method. Or consider agreeing on a valuation at the time of conversion, which may or may not depend on certain (sales) targets.
  • Founders should be wary of a Valuation cap. A cap on valuation is only in the interest of the investor and can lead to the investor receiving a larger stake than one would expect based on the actual valuation of the company. This means founders will have to dilute more.
  • Think ahead and be wary of the standard clause found in nearly all templates that gives the CLA holder equal rights and an equal position as a prospective Series-A investor. Series A investors often receive significantly more favorable (financial) conditions such as liquidation preferences and down-round protections, which would in turn also apply to the CLA holder. Especially if the CLA holder receives many more shares through a Cap or a Discount than you would expect based on his deposit, a liquidation preference can cost the founder dearly. Limit it to the cash-invested amounts and, if necessary, create another (shadow) class of shares.
  • Want to set up an employee incentive plan? Then make room for employee participation now and reserve a percentage in the CLA documentation for the ESOP or Employee incentive plan.
  • The parties will still have to enter into a shareholder agreement after conversion. The investor is protected in a shareholder agreement (often as a minority shareholder). The founder will also have to worry about his or her own position. Negotiations on the content of the shareholder agreement ideally take place before the CLA is concluded, but often there is no time for this or these talks are postponed. At conversion, your negotiating power has declined, because the investor and founder are already bound by each other. In the case of a conversion due to a Series A funding, the negotiations for a shareholder agreement might become complex and the holder of the CLA sometimes gets a strong negotiating position.

A CLA can be kept very simple, but in practice we increasingly see CLAs covering many pages and with some increasingly exotic deal terms. To get you started, below is a brief description of the standard terms and some of the more exotic ones.

Common clauses and deal terms

With knowledge of the following common clauses, you will be well prepared in negotiations with potential investors:

Principal amount – the amount the investor lends. Sometimes it is a lump sum, but payment in several tranches or parts is also possible (although I wouldn’t recommend it), whether or not linked to certain achievements (milestones), such as the introduction of a product on the market or a certain number of products sold. Also common is the promissory note: an amount that will be made available at the company’s first request. Principal amounts once provided or drawn generally are non-repayable. It is up to the holder of the CLA whether the Principal converts or must be repaid on a trigger event, but founders (and investors) should prefer automatic conversion.

Interest – interest accrues on the principal amount as long as the CLA is outstanding. With a regular loan, interest is often paid monthly or quarterly. With a convertible loan, the interest is usually added to the loan and, on the Maturity Date (see below), converted into shares along with the Principal or repaid in a lump sum. This can easily save a (few) percent in equity interest of the company. As a business owner, opt for a simple interest rate (to avoid interest-on-interest, which is called a compound interest rate). An interest rate of 4% to 7% is common.

Maturity date – the end of the duration of the convertible loan and often a trigger event for conversion or repayment. It indicates the duration of the CLA. A maturity date of one year after the effective date is rather short, two to three years is common, and more than five years is long.

Collateral – in bank financing, collateral is perfectly common. With a convertible loan, you actually never see collateral. The risk for the investor is higher in that respect, but so is the interest rate and equity stake after conversion. The CLA does offer the investor a somewhat stronger position prior to conversion than that of shareholders. Shareholders are at the back of the queue in the event of bankruptcy and rarely receive any distribution from bankruptcy. During the term of the CLA, however, the investor is an ‘ordinary’ creditor who shares in proceeds before the shareholders. However, the investor would do well not to count on any actual distribution; the percentage of bankruptcies in which a distribution to unsecured creditors is possible is very small and a distribution on unsecured claims rarely exceeds a few percent.

Trigger events – the trigger events, as mentioned, determine when the convertible loan can be converted into shares by the investor. Reaching the maturity date was discussed above: at the end of the duration of the convertible loan agreement, the loan is convertible (often at the option of the CLA holder) into shares. Another trigger event is reaching Qualified financing or Next equity financing: if a new investment round is closed, the investor may convert at the same price as the investors in the new investment round, with or without a discount (see below). The advantage of this is that parties immediately see their valuation problem (partially) solved. Finally, an Event of Default is often a trigger event. An Event of Default can occur, for example, if the company fails to comply with obligations agreed to in the CLA, is declared bankrupt, ceases its business or changes the nature of its business significantly. Also, the departure of the Founder (in combination with a change of control clause) or the departure of key personnel is sometimes included as an event of default or separate trigger event. Finally, a Liquidity Event or an Exit can also be included as a trigger event. A Liquidity Event might be a sale of the entire company.

Conversion Shares – the provision on conversion shares is often included in the definitions. It determines what type of shares are issued to the holder of the CLA upon conversion. Generally, it is the most senior class shares, or the highest ranking shares. As a Founder, you should be aware that any statutory liquidation preferences are often tied to the most senior class of shares. If the Founder does not intend for the investor to benefit from a liquidation preference, that will have to be ruled out. As a Founder, you might want to consider to opt for ordinary shares or depositary receipts in a corporate structure with a Trust foundation (StAK).

Calculation of conversion – the CLA will also generally include a formula or description of how parties can arrive at the price per share. The price per share determines how many shares can be issued at the principal plus accrued interest to be converted, so this formula is very important. Commonly used formula for calculating the price per share is the pre-money valuation divided by the company’s fully diluted capitalization. Make sure that rights acquired as a result of the current CLA do not count toward the fully diluted capitalization, a common mistake. A fixed percentage convertible is also possible, where the investor obtains a predetermined percentage of the share capital upon conversion. Yet another variant is a predetermined valuation, possibly combined with an adjustment event; an event on the basis of which the predetermined valuation is adjusted again.

Discount – if conversion of the loan takes place with Qualified financing or Next equity financing, the holder of the CLA often wants to convert along with the investment round. Common condition is that that conversion then occurs at a discount: a discount on the price paid by the investor in the next equity round. Thus, the holder of the CLA receives an additional reward for early entry.

Valuation Cap – in conversion, the valuation of the company is important. The valuation has the most influence on the amount of shares to be issued. Thus, it determines the interest the investor acquires and the interest the founder retains. A high valuation is in the interest of the founder, a lower valuation is in favor of the investor (hence the discount!). In order to protect the holder of the CLA (at least, to promise the holder of the CLA an additional advantage), a valuation cap is often included: the maximum value at which the shares must be issued. In the case of a (pre-money) valuation of the company of EUR 5 million and 10,000 outstanding shares, the price per share to be issued is EUR 500. The holder of a CLA of EUR 1 million will in principle receive 2,000 shares or 16.67%. With a valuation cap of, say, EUR 3 million, the holder of the CLA gets shares at a price of EUR 300 per share, which means that 3,334 shares must be issued, or 25%. So think carefully before including a valuation cap.

Shareholders’ agreement – after conversion, the holder of the CLA becomes a shareholder. A shareholders’ agreement must be entered into between shareholders. Often the CLA documentation describes that the shareholders’ agreement to be entered into will contain ‘the usual and market-standard’ provisions to protect minority shareholders, with customary information rights. Founders will need to be aware of two things. First, these provisions often include, that in case of conversion following a qualified financing, the holder of the CLA gets the same rights as the investor in the qualified financing. However, that is often a much larger investment round where many more (information) rights must be disclosed than in early seed or angel rounds. The question is whether the holder of the CLA with (probably) only a minority stake deserves the same position. Second, the founder should be aware that the CLA holder must be directly involved in the negotiations of the shareholder agreement with the prospective investor. This gives the CLA holder a key position. One solution is to already negotiate in the CLA documentation what rights the CLA holder will have after conversion. This would make the documentation more expensive and complex, but delay could also cost the founder dearly.

Warranties – investors and prospective CLA holders often request warranties from the founders. Standard warranties are the incorporation guarantee (the legal entity exists, is properly incorporated in line with Dutch law) and the warranty that all corporate law steps have been taken to be able to enter into the CLA, such as the presence of a shareholder resolution. Especially for technology start-ups, it is wise as an investor to ask for warranties regarding the intellectual property: that the legal entity is entitled to the IP and that all rights have been filed or registered and that all fees have been paid.

Covenants – before a CLA converts, the holders of the CLA are debt providers. In principle, they have no say in how the business is operated and they have no role in its governance. It is different with shareholders, who have all sorts of rights based on Dutch corporate law, articles of association and the shareholders’ agreement. But CLA holders are not shareholders (yet). This is why the CLA documentation may contain language to the benefit of the investor on items such as information rights and corporate actions that will require prior approval of the CLA lenders. Covenants and the restrictions they entail are often overlooked by founders.

Most Favorite Nation – to the extent that raising additional convertible loans or issuing new shares is not blocked by covenants, CLA holders sometimes ask for most favorite nation treatment, meaning they are compensated for any more favorable terms given to any subsequent lender. The most favorite nation can be limited to financial terms, such as valuation, cap, discount, but also, for example, a liquidation preference. Founders should be wary of such provisions.

Down Round – a down round clause in CLAs often becomes active only in the period after conversion. A down round occurs when the valuation of the company declines between the moment of conversion and a subsequent financing round. Subsequent investors then step in at a (sometimes much) lower price per share than the former CLA holder, possibly resulting in substantial dilution. With a down round clause, investors protect themselves against this dilution. Down round protection often means that additional shares must be issued to the former CLA holder at no additional consideration (though pursuant to Dutch law, par value will have to be paid, which is often negligible). A weighed average approach is also possible. Although the weighted average approach is somewhat more founder-friendly, a down round clause can be quite detrimental. With down round protection, CLA investors effectively try to put the risk of depreciation back on the founders. One could argue that this very risk is all in the game.

Want to know more?

Want to know more about convertible money loans or have a question? Then contact Paul Passenier or call +31 30 23 22 373.

Paul Passenier - advocaat financiering ondernemingsrecht
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