Convertible loan for startups: flexible financing without immediate valuation

What is a convertible loan?

A convertible loan is a hybrid financing instrument. Initially, an investor provides a loan to the company, but under pre-agreed conditions, that loan can later be wholly or partially converted into shares.

This hybrid nature makes the convertible loan attractive. On the one hand, it's a debt: the startup receives money, generally pays interest, and must repay the principal. On the other hand, it includes an equity component: the investor gets the opportunity to participate in future value growth through shares.

In practice, various forms of convertible loans exist. The most common variant is the standard convertible loan, often structured as a private agreement between the investor and the company. Additionally, there are variants such as the convertible bond, the mandatory convertible loan, the reverse convertible, and a convertible loan with a cash settlement option.

For startups and scale-ups, it's particularly important that this instrument offers flexibility. It enables quick financing without the need to fully structure an equity round on day one.

Why do startups and scale-ups choose a convertible loan?

The biggest appeal of the convertible loan is that the valuation discussion can be postponed. In an early stage, this is often a significant advantage. Young tech companies, in particular, often have a strong growth narrative but limited historical figures. In such cases, it can be difficult to agree on a valuation that satisfies everyone right away.

With a convertible loan, the company can still attract capital, while the valuation only becomes concrete later, for example, during the next investment round. This provides room to further develop the product, revenue, or traction first.

Furthermore, the documentation is often more concise than for a full equity round. This can save time and transaction costs. For companies that need quick funding, for example, as a bridge to the next round, this is a significant practical advantage.

From the founders' perspective, this is also attractive. There is no immediate dilution at the time the loan is granted. That dilution only occurs when the loan actually converts into shares. For teams that expect their valuation to increase in the short term, this can be a significant strategic advantage.

For investors, the appeal lies primarily in the combination of downside protection and upside potential. As long as it hasn't converted, it's a debt claim. At the same time, the investor can later acquire shares on favorable terms if the company grows.

The Legal Core: A Convertible Loan is More Than Just a Loan

Although convertible loans are widely used, Dutch civil law does not have a separate, fully developed regime that specifically regulates this instrument. This does not mean it's legally non-binding. On the contrary: precisely because of its hybrid nature, multiple legal areas are simultaneously involved.

With a convertible loan, at least three layers are intertwined. Firstly, contract law, because parties record their agreements in the loan agreement. Secondly, corporate law, because conversion ultimately leads to the issuance of shares. And thirdly, depending on the structure, securities law aspects also come into play.

This has practical consequences. Anyone who focuses solely on the commercial deal but not on the corporate law implementation risks the loan appearing clear on paper but encountering issues during conversion due to powers, formalities, or missing resolutions.

For startups, this is a crucial point. A convertible loan sometimes seems like a quick and easy solution, but its simplicity primarily lies in postponing certain discussions. The legal work doesn't disappear; it shifts.

How does conversion work legally in practice?

The conversion of a convertible loan into shares essentially occurs in two steps: the issuance of shares and the offsetting of the loan against the payment obligation for those shares.

1. Issuance of shares

The first step is the issuance of shares. This requires a resolution from the body authorized to issue shares. Which party that is depends on the law, the articles of association, and the company's internal governance. In many cases, the general meeting plays a central role, but it is also possible that another body has been authorized.

Additionally, it is necessary to check whether a right to subscribe for shares has already been granted. If the convertible loan is structured in such a way that this right has already been correctly granted, a separate issuance resolution may not be necessary at the time of the actual conversion. This can prevent a lot of friction.

The type of shares is also relevant. If parties have agreed that a specific share class will be issued upon conversion, the company must have the appropriate legal basis in its articles of association to actually issue those shares. If this is lacking, an amendment to the articles of association may be necessary.

For startups, this means you cannot view the cap table and governance independently of the loan. Anyone who quickly signs a convertible now must simultaneously consider whether the corporate structure is ready for the later conversion.

2. Set-off against the payment obligation

After the share issuance, the conversion is not yet legally complete. At that moment, two parallel obligations exist. The investor still has a claim against the company under the loan, while that same investor, as a new shareholder, has an obligation to pay up for the acquired shares.

These two positions must be set off against each other. In practice, this is an essential part of the conversion. Without a clear agreement on this, unnecessary uncertainty arises.

This is precisely where things often go wrong in poorly drafted documentation. Set-off is not an afterthought, but a core component of a workable convertible loan. For an effective structure, the company must agree to this set-off. Only then will the legal implementation align well with the commercial intent of the parties.

At Startup-Recht, we regularly see that founders primarily negotiate discount, cap, and timing, while the corporate mechanics only receive attention later. That is understandable, but risky. A convertible loan is only truly well-arranged if the path to valid conversion is also properly secured.

What agreements should be included in a good convertible loan?

The flexibility of a convertible loan is an advantage, but it makes clear documentation all the more important. The more ambiguity parties leave, the greater the risk of disputes during a funding round, exit, or maturity.

Conversion price and conversion ratio

The core of the deal usually lies in how the conversion price is determined. Often, it aligns with the price per share in a subsequent funding round. Additionally, parties can agree that the investor receives a discount on that price.

Such a discount is understandable. After all, the investor invests earlier and takes on risk in a phase where the company is often less developed. The conversion right can therefore be seen as additional compensation besides the interest.

A valuation cap is also frequently included. With this, parties agree on a maximum valuation at which the investor is willing to convert. This can offer protection to the investor if the next round takes place at a much higher valuation. At the same time, it must be prevented that such a cap unintentionally turns into a disguised valuation negotiation at a time when the convertible was precisely intended to postpone that discussion.

Triggers for conversion

Besides the price, the moment of conversion is at least as important. The agreement must clearly state which events trigger conversion.

Common triggers include:
a subsequent investment round, the expiration of a predetermined term, the achievement of certain milestones, an IPO, or a change of control.

Especially with startups, precision is important here. What exactly qualifies as a new funding round? When is a milestone achieved? When does a change of control occur? The more concrete these definitions, the smaller the chance of discussion when the stakes are high.

Principal, interest, and term

The classic loan elements also warrant attention. The agreement must clearly specify the loan amount, interest rate, and term.

With convertible loans, interest is often less dominant than with standard loans, as investors typically focus on the potential value of shares post-conversion. In practice, interest is also frequently accrued and converted alongside the principal. While interest rates vary, they are often lower than those for a regular loan.

The term, and specifically the maturity date, is a crucial benchmark. If no conversion trigger has occurred before that date, it must be clear what happens next. Does the loan become repayable? Does the investor still retain a conversion right? And in that scenario, how is the conversion price determined if no financing round has taken place yet?

This is precisely where many misunderstandings arise in practice. A convertible loan is not just a financing instrument for the present; it also represents a set of agreements for when the anticipated trigger does not materialize.

Early exit

Another point that often warrants attention is an exit prior to the intended conversion event. If the company is sold early, it's logical that parties would have considered the investor's position.

For instance, it can be agreed that in such a scenario, in addition to repayment of the loan and interest, the investor receives a multiple on the loan amount or participates pro rata in the sales proceeds. This prevents the investor from being economically disadvantaged compared to shareholders, especially since their capital bore risk earlier.

For founders, this is a crucial negotiation point. An early exit clause can significantly impact the economic outcome, particularly in scenarios where the company is sold sooner than anticipated.

Most Favored Nation

Sometimes the loan also includes a Most Favored Nation clause, often abbreviated as MFN. Such a provision means that if more favorable terms are later agreed upon in new loan agreements, those improved terms can also extend to the existing convertible loan.

This provides comfort to investors. It reduces the risk that they invested too early under terms that soon after prove to be less favorable than those offered to later financiers.

For startups, this is a point to carefully consider. An MFN clause might seem minor, but it can significantly impact the flexibility for future bridge financing or additional convertible debt.

Convertible loan, SAFE or warrant: what's the difference?

In the startup world, various instruments are often conflated. However, their legal and economic distinctions are significant.

A warrant loan differs from a convertible loan. With warrants, the investor gains the right to purchase shares at a predetermined price within a specific period, while the loan itself remains outstanding. This is a distinct structure from a loan that converts directly into equity.

An exchangeable bond also differs fundamentally. It involves an exchange for other securities, such as shares in a group company, rather than conversion into the borrower's own shares.

Then there's the SAFE. Economically, it sometimes resembles a convertible loan because it also defers the valuation question. Legally, however, it's a different instrument. A SAFE does not qualify as debt, isn't listed as such on the balance sheet, and typically has no interest or repayment date. Therefore, for Dutch startups, it's crucial not to assume that all these instruments are interchangeable.

The advantages and disadvantages of a convertible loan

Advantages for startups and scale-ups

For early-stage growth companies, convertible loans offer clear advantages. The most important are speed, flexibility, and the deferral of valuation discussions.

This is relevant for tech companies that need capital quickly but don't yet see a logical moment for a full equity round. For example, because crucial milestones haven't been met, commercial traction still needs to be proven, or the company simply wants to buy time before a larger round.

Additionally, a convertible loan can be attractive because it doesn't cause immediate dilution. Founders keep the cap table clearer in the short term, while the company still attracts funding.

Advantages for Investors

For investors, the convertible loan combines flexibility with a potentially attractive entry point. With value growth, the investment can convert into shares under favorable terms, for example, through a discount or cap.

At the same time, before conversion, it remains a debt position. In theory, this gives the investor a better position than a shareholder. This makes the instrument more attractive to certain investors than taking direct equity.

Disadvantages and Points of Attention

The downside of flexibility is that ambiguity quickly becomes costly. The more open the agreements, the greater the chance of friction as soon as something actually happens: a round, an exit, a maturity, or a price discussion.

For founders, the risk primarily lies in underestimation. A convertible loan often feels light at signing but can later have a significant impact on dilution, governance, and negotiation leverage.

For investors, the risk lies precisely in interpretation and execution. An attractive economic agreement is worth little if corporate decision-making, authorities, or settlement agreements are not properly arranged.

What Startups Should Pay Special Attention To

For startups and scale-ups, a convertible loan is particularly suitable when speed and flexibility are desired, but only if the legal foundation is taken as seriously as the commercial deal. Therefore, pay attention to these points in any case:‍

Is it clear which body is authorized to issue shares?
Is it regulated whether and when pre-emptive rights must be excluded?
Does the statutory structure align with the type of shares to be issued upon conversion?
Is it crystal clear how the conversion price and conversion ratio are calculated?
Are the conversion triggers described concretely enough?
What happens on the maturity date if no trigger has occurred?
How is an early exit handled?
Is offsetting against the capital contribution obligation explicitly stipulated?
And if an MFN clause is included: what is its exact scope?

These are not minor details. These are precisely the points where a convertible loan either functions smoothly in practice or runs into problems.

Conclusion

The convertible loan is a powerful financing instrument for startups and scale-ups. It offers the opportunity to quickly attract capital, postpone valuation discussions, and bridge to a next funding round. Precisely for this reason, it's crucial not to focus solely on today's speed, but also on tomorrow's legal feasibility.

Anyone looking to effectively utilize a convertible loan must therefore look beyond just the cap, discount, and interest. The true quality lies in the combination of smart commercial agreements and a structure that remains legally sound even upon conversion, exit, or maturity.

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