Start-ups and coronavirus: Convertible loans as a financing instrument in the coronavirus crisis
The coronavirus pandemic has triggered a severe global recession and poses challenges to our society and economy alike. Exports, private consumption and investments have slumped, leading to dramatic losses in sales for many companies. For start-ups, these effects are in some cases even more noticeable, as most start-ups naturally lack reserves to survive in times of crisis.
Currently, funding rounds are being delayed and decisions on investments postponed because investors include an evaluation of how the start-up manages the coronavirus crisis in their investment decisions and have to critically assess what the growth outlook is in a changing market environment. Of course, investors are also feeling the impact of the pandemic in their portfolio and will therefore be particularly careful when deciding whether and to what extent to invest in new start-ups, rather than withhold their capital for possible liquidity shortages in existing investments.
The €2 billion funding provided by the German federal government as part of the start-up package is unlikely to change this (for the €2 billion package, please see here) as the support from the Corona Matching Facility (pillar 1 of the package of measures) conceptually presupposes, first of all, the willingness of the European VC funds to invest, whose investment can subsequently be matched by CMF funding. It appears that most of the VC fund managers interested in the Corona Matching Facility would want to benefit from such matching at most for their existing portfolio and not for new investments.
In such times of crisis, convertible loans are a useful financing instrument for high-growth companies. Convertible loans have been a proven and well-established financial instrument in the start-up scene for years. The basic mechanism and the regulatory elements of convertible loans are likely to be sufficiently well known to anyone dealing with start-up financing: A convertible loan is a loan (usually unsecured) with a right or obligation to subsequently convert the loan (plus accrued interest) into new shares to be issued (mostly in the course of the next round of financing). The basic idea of a convertible loan agreement is conversion into equity and not repayment of the loan, although repayment of the loan is also possible. The convertible loan normally bears interest. For the payment of interest, final maturity is usually agreed in order to avoid burdening the start-up’s liquidity with ongoing interest payments.
In particular, due to the possibility of a postponement of the valuation question and the rapid and cost-effective implementation, as well as the flexibility in relation to its terms, the convertible loan will, in our view, in the coming weeks and months, be more and more the instrument of choice among the various financial instruments, as will be explained in more detail below.
Overcoming valuation uncertainties for start-ups
The valuation of a start-up is based on a number of factors that make it possible to determine the potential of the start-up and the validity of its business model. Probably the biggest difference between the valuation of start-ups and mature companies is that there are naturally (almost) no historical figures for start-ups. This is often the case not only for individual start-ups, but also for particularly innovative business models in the whole market in which the start-up operates. In contrast to mature companies with an extensive financial history, it is therefore difficult to forecast the financial returns of start-ups. Put simply, a company valuation of start-ups is far less likely to be derived from existing figures and therefore tends to be roughly estimated. It is based on soft factors, such as the track record of a serial founder, the investor’s confidence in the (founder) team and the business plan, or is simply a matter of negotiation between the investor and the founder team.
The coronavirus crisis has made valuations even more difficult, and precrisis valuations are often no longer tenable. If the founders and investors cannot agree on the valuation at which equity financing is to take place, or if a realistic valuation is not possible, financing by means of a convertible loan may be a meaningful precursor to equity financing. Valuation issues are postponed by typically agreeing in the convertible loan agreement that the lending investor’s claim will only be converted to equity in the next round of financing, based in principle on the valuation of this next round of financing. Valuation uncertainties are thus overcome or delayed. A time-consuming valuation process can be avoided and urgently needed liquidity can be obtained relatively quickly. This makes convertible loans particularly attractive as a financing instrument during the coronavirus crisis.
Avoidance of down rounds
Due to the impact of the coronavirus crisis, valuations of start-ups are often corrected downwards. However, a down round should be avoided, especially from the point of view of the start-up and the founders. It results in a loss of value and a dilution of the existing shareholders’ stakes, as investors will receive a higher stake for the same investment amount than they would have received in the previous financing round due to the company’s lower valuation. Although participation agreements often provide for down round protection, this only results in compensation for the dilution for selected investors (and typically not for the founders or other holders of shares without preferential rights).
The postponement of the valuation makes it possible to avoid down rounds and a severe dilution of the founder team and the other holders of non-preferential shares and, consequently, also a demotivation of the founders. Instead, start-ups and management are encouraged to ‘drive the company forward’ until the next round of equity financing in such a way that the best possible valuation can be achieved, on the basis of which the conversion of the convertible loan can then be made. This also limits the dilution of the founder team and the other non-preferential shareholders.
Broad freedom of contract
An additional advantage of convertible loans which makes them particularly attractive as a crisis management tool is a wide-ranging freedom of contract. The vast majority of German start-ups are structured as limited companies (GmbH). The German Limited Companies Act does not contain any specific requirements for convertible loans. The parties involved are therefore largely free to define the terms of the convertible loan agreement.
Typical terms in a convertible loan agreement are, for example, the discount, the cap and the floor:
If, as usual, a discount is agreed, the lending investor receives a (percentage) discount on the start-up’s valuation on which the funding round is based. This is often an incentive for investors to grant a convertible loan.
A cap can be used to determine the maximum valuation on which the conversion will be based in the next round of funding. The cap applies when the funding round is carried out at a higher valuation than the valuation agreed as a cap. While the new investor invests at the higher valuation, the conversion is based on the valuation agreed as a cap.
On the other hand, a floor is agreed as a minimum value for conversion. The floor is used when the funding round is carried out at a lower valuation than the one defined as the floor. While the new investor invests at the lower valuation, the conversion is based on the valuation agreed as a floor. From the point of view of the founders and the other shareholders, the floor is therefore a useful means of avoiding an unpredictable dilution. However, it will rarely be possible to enforce it with the investors in the negotiations, at least when, as is currently the case, valuations are under pressure as a result of the crisis.
These well-known market-typical instruments (discount and cap) make it possible to address specific risk profiles in a timely and virtually continuous manner. For example, flexible discounts may be agreed, which will continue to grow (up to a certain amount) as time elapses between granting of the loan and the next round of financing. We expect that due to the current valuation uncertainties, discounts will tend to increase rather than decrease.
However, when agreeing on a cap, it should be borne in mind that it may also influence the valuation of the next round of financing. A new investor will want to have existing convertible loan agreements disclosed during the due diligence process, and any valuation above a cap will probably have to be extensively documented or will be difficult to enforce.
The concept of contractual freedom provides the parties with additional means to address the specificities of the current crisis situation and its concrete impact on the start-up. For example, milestones rules and splitting loans into tranches can be used as instruments to tackle the crisis in several steps. Disbursement of any tranches can be made conditional, for example, to the start-up adopting or implementing certain measures to mitigate the impact of the coronavirus crisis.
Avoiding insolvency and summary termination
It is also crucial to provide for a qualified subordination in the convertible loan agreement. This was already a standard element before the onset of the coronavirus crisis. If the loan claim (plus interest) is assigned a qualified subordination in the convertible loan agreement, it does not have to be carried as a liability in connection with the determination of the arithmetical over-indebtedness in the over-indebtedness status, with the result that there is no arithmetical over-indebtedness and the start-up can be prevented from sliding into insolvency. Arithmetical over-indebtedness is an element of the over-indebtedness audit under insolvency law, in addition to (the absence of) a positive continuation forecast. Information on the temporary suspension of the obligation to file for insolvency and protection against insolvency filing by creditors in the wake of the coronavirus crisis can be found here.
From the point of view of the start-up (as a borrower), special caution is currently required when formulating the grounds for termination. The wording sometimes used in this respect, namely that termination for cause remains unaffected, is not sufficient. Under section 490(1) 1st sentence German Civil Code, in the event of a (looming) substantial deterioration in the debtor’s financial situation, among other things, the debtor may be terminated with immediate effect. Given the current crisis environment, many start-ups must be prepared for such deterioration at any time, whereby the risk of a short-term maturity of the loan would then exist. However, since the above mentioned provision is optional, the right to terminate the convertible loan agreement with immediate effect for cause should be explicitly excluded from the perspective of the start-up. The same applies to the provision in section 321 German Civil Code (defence of uncertainty). Moreover, all permissible grounds for termination should be defined as specifically and narrowly as possible in the convertible loan agreement.
Combination with changes in governance
Convertible loans can also be combined with changes in governance or other (specific) amendments to existing contracts (in particular the shareholders’ agreement). They are therefore suitable as a financing instrument even if deeper changes to the shareholder structure or the strategic orientation of the start-up are necessary due to the crisis. Investors who are willing to provide funding to the start-up even during the crisis often demand a significant increase in control, for example through an additional seat on the advisory board or further veto rights with regards to company law or management measures. This can be reflected in the convertible loan agreement or a related shareholders’ agreement. However, this also adds to the complexity of contractual documentation. Standard ‘off-the-shelf’ templates will certainly not be suitable here.
Little effort and low costs
In the crisis, many start-ups quickly need liquidity to preserve their financial room for manoeuvre. A convertible loan agreement can be negotiated and implemented within a few days, especially if the lending investors are already shareholders of the start-up.
In principle, a convertible loan agreement does not have to be concluded in any particular form. In any event, there is no obligation for notarisation where existing shareholders grant a convertible loan.
If, on the other hand, the convertible loan is granted by a new investor, accession to the applicable shareholders’ agreement is provided for, which, due to regulations on a drag along, is itself subject to formal requirements pursuant to section 15(4) German Limited Companies Act, and results in the convertible loan agreement having to be notarised. However, such accession is not necessary if the lending investor is already a shareholder of the start-up, and therefore a party to the shareholders’ agreement.
Convertible loan and the €2 billion package of measures
Also in the context of the implementation of the German federal government’s €2 billion package of measures, convertible loans will play a significant role, in particular due to the possibility of postponing the valuation issue.
Pillar 1: Coronavirus Matching Facility
The coronavirus Matching Facility allows European VC funds to have their investments matched with federal funding. Classic equity financing, convertible loans or subordinated shareholder loans may be considered as possible financing instruments. It is exclusively up to the investing VC fund to select the most suitable instruments, as it is the VC fund which, together with other investors, will negotiate the individual terms of the contract with the start-up (e.g. conversion and repayment arrangements, exit scenarios, etc.).
Pillar 2: Start-ups without access to Pillar 1 and small mid-caps
The specific support structure is likely to vary from one federal state to another. More detailed information on this is still not available. Some regional development banks are already supporting start-ups by granting convertible loans. For example, NRW.BANK grants convertible loans of up to €200,000 under the ‘NRW.Start-up akut’ programme.
Since 8 June 2020, KfW bank group has also provided the regional development banks (Landesförderinstitute) with global loans with indemnities to finance start-ups that do not have access to Pillar 1 and small SMEs. Regional development banks can use these funds to refinance region-specific support programmes. Depending on the programme, this may take the form of mezzanine or equity financing, e.g. financing through open or silent equity holdings or even convertible loans.
As long as the impact of the coronavirus crisis on start-ups’ business models cannot be conclusively assessed, we believe that the convertible loan is a useful and efficient financing instrument. It is well established in the market, can be implemented quickly and in a cost-effective manner, and offers the participants flexibility to overcome the coronavirus crisis. However, before granting convertible loans, investors will critically assess whether the business model of the start-up to be financed is sufficiently valid and is also likely to be successful in a market environment that may be altered long term by the coronavirus crisis.
Any questions? Please contact: Ariane Neubauer, Anka Ehrich or Felix Blobel
Practice Group: Private Equity