Handle with Care: Convertible Loans for Initial Startup Investments (Business Angels FrankfurtRheinMain e.V.)

Summary

• A convertible loan is typically an unsecured loan from investors to a company, where repayment is not intended and conversion into shares is planned for a later date.p.1
• The author argues that initial investments via convertible loans bring disadvantages for new investors, the company and existing shareholders.p.1
• The conversion cap is de facto a first company valuation, so the argument that a convertible loan saves a valuation does not hold.p.2
• A ZEW study finds that investors receive 4.5% of shares in the founding year with equity financing, but only 2% with convertible loans.p.4
• Convertible loans can create conflicts of interest because a loan giver gets more shares if the valuation is lower.p.3
• Convertible loans can make sense for internal bridge financing by existing shareholders.p.5

Key insights

1. Convertible loans are widely used in the startup environment because they are quicker to set up than a capital increase.p.1
2. The speed and simplicity argument is a myth, because the equity financing negotiations are merely postponed to the future.p.2
3. A convertible loan pre-empts the framework of a future financing round, limiting flexibility for follow-on rounds.p.2
4. A latent conflict of interest arises because an investor adding value before conversion works against a larger share of the startup.p.3
5. In the founding year, 4.5% of shares go to investors in equity financing but only 2% with convertible loans, and the valuation gap closes three years after founding.p.4
6. Loans are debt capital, not equity, and can lead to a balance sheet item showing a deficit not covered by equity.p.4
7. Managing directors risk personal liability if no notary was involved in the convertible loan.p.6