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Seed Round with Convertible Loans: What you need to know

 

Post written by Michael Baier and Michael Tschudin.

The granting of convertible loans (“CLs”) has become increasingly popular for seed round financings of start-ups. In fact, many business angels prefer to invest in this structure. The reasons for this are manifold: compared with equity rounds, it is relatively fast, the agreements are shorter and simpler and the overall transactions costs can be lower.

Convertible loans are just that: loans. The loans will convert into equity (usually preferred shares) at such time as the next financing round is raised. Despite this simplicity, there are certain issues, which must be kept in mind when issuing convertible loans.


Economics: Valuation Caps & Floors / Discounts

Convertible loans are considered easier than equity financing because no valuation of the start-up is set and you get to avoid this part of the negotiation. However, investors and start-ups/founders will still have to think about economic implications:

Investors want to ensure that their price per share at the conversion event is not too high and therefore will ask for a discount (10% to 20% being the most common) and a cap (= max. valuation of the start-up at the conversion event). This might not work for the start-up, as a low valuation cap for the seed round can cause future investors to shy away (since investors might feel they could overpay if valuation has increased significantly). Also, future investors might focus on the cap set for their own valuation of the start-up. This leads to a scenario where the start-up underpriced itself by setting a low valuation cap in the preceding seed round. To mitigate this risk, the start-up should try to not disclose the seed round terms until a price has been set with the new investors. Lastly, from an entrepreneur’s perspective, CLs should have a valuation floor (= min. valuation), instead of a cap, so that the CL investors do not get shares too cheap.


Conversion Mechanics & Governance Matters

When a start-up plans to issue CLs it needs to comply with a few statutory provisions: First, it generally needs to grant (pro-rata) preferential rights to all existing shareholders to subscribe for the CLs to be issued. Second, the board of directors of the start-up has to ensure that in the event of the conversion, the required number of shares is available, without having to consult the shareholders first.

Upon a conversion event, the CL investors automatically become shareholders. It is therefore crucial that they undertake, in the CL agreement to adhere to the then existing shareholders’ agreement (of the start-up).


Taxes & 10/20 rule

The CL investor will want to have a minimum upside from his investment in the form of an interest rate for the loan granted. Interest rates cannot be agreed at the discretion of the parties; the Federal Tax Authority (FTA) publishes annual ‘safe harbour’ tax rates for (shareholder) loans. If the interest rate deviates from these safe harbour rates, the portion that is too high is considered to be a hidden dividend distribution and the portion that is too low is considered to be a hidden capital contribution.

If a start-up grants more than 10 loans with identical terms, or more than 20 loans with different terms, with a total principal amount of at least CHF 500,000, interest payments are subject to a 35 % withholding tax. Depending on where the CL investors are located, such withholding tax may not be reclaimed in full or at all. In any case, the start-up needs to avoid taking on CLs from any more than 20 investors, as otherwise it will qualify as a bank (with the need for a license!).

 

Convertible loans are a real and viable alternative to equity rounds, in particular for seed financings. They are in fact simpler and faster to handle. However, the foregoing has made it clear that careful drafting is key as it saves the start-up, the founders and the investors from legal and tax problems.

Feel free to reach out – we are happy to answer follow-up questions and to support you in your seed financing round!