Convertible loan

A convertible loan is a special loan agreement. It is particularly suited for the GmbH (limited liability company). The investor (lender) accepts to make a certain amount of money available to the GmbH (borrower). Usually, the loan bears interest. Subject to certain predefined conditions, the lender has the right or even the obligation to convert the loan amount into equity capital of the GmbH. I.e. the borrower does not have to pay the loan back. Instead the GmbH (borrower) issues shares to the lender and the value of such shares is equal to the loan amount plus interest.

A convertible loan is particularly suited for bridge and interim financing. A liquidity shortage, arising in between two financing rounds, can be avoided. On top of this, convertible loans grant the chance to achieve a higher company valuation, by postponing the moment of the valuation to a future date. However, convertible loans may be used systematically as an instrument for financing. Their advantage is that they commonly provide for so called qualified subordination clauses. Thanks to these the GmbH can avoid to become overindebted. At the same time, they do not dilute the interests of the existing investors, in the first place.

If the investor (lender) accepts to subscribe for shares in a GmbH (limited liability company) subject to certain conditions, then the convertible loan must be notarised. A German court decided that way for a lender who has not been a shareholder of the GmbH at the time of the signing of the convertible loan. To ensure it‘s validity, the convertible loan should therefore in general be notarised. Otherwise, the whole agreement may be void. This has serious consequences with respect to the subordination clause. In case the subordination clause is not valid, the GmbH is threatened to become overindebted. This represents a reason for the opening of insolvency proceedings. Should this fact be missed, the managing directors are even exposed to a risk of personal liability.

A financing round which reaches certain key figures constitutes a qualified financing round. These key figures are individually determined in the convertible loan agreement. If all key figures are met, it constitutes a qualified financing round and in general, the loan must be converted. Often, the financing round must be carried out within a certain lapse of time, e.g. two years. Further, fresh capital in a certain amount, e.g. 1 Mio. €, must be raised from new investors. It is possible, too, that the GmbH (limited liability company) must reach a certain valuation, e.g. 5 Mio. €. A financing round which does not meet all the predefined key figures, constitutes a simple financing round.