A convertible loan is a popular investment means to finance a start-up. Austrian law, however, does not foresee convertible loans for the most popular corporate form of Austrian start-ups: limited liability companies. Convertible loans thus have to be synthetically structured.
What are convertible loans and why are they a popular investment means To fi-nance start-ups?
Convertible loans are typically loans that provide the lender (investor) the right to convert the loan into equity of the borrower. Sometimes the right is replaced by a fixed con-version procedure upon occurrence of a certain event or upon expiry of time. Convertible loans are popular amongst start-up investments and financing because they defer one of the major obstacles of start-up transactions: the valuation of the start-up. Due to their nature, the parties do not need to agree on a valuation of the start-up for a convertible loan. The parties simply need to agree on (i) the principal loan amount and interest; and (ii) when the conversion shall take place. In the start-up world, conversion is typically connected to the subsequent equity financing round, ie when the start-up receives its next valuation. Upon such event, the loan (including accrued interest!) is converted into equity on the basis of the valuation of the financing round. Convertible loans thus allow faster execution than ordinary financing transactions.
Key incentives for investors
Lenders under convertible loans are typically incentivised not only by being able to use the accrued interest at conversion (thereby increasing the potential share in the start-up after time), but also by agreeing on a discount on the future valuation (typically around 10 %). The discount allows the investor to receive a higher equity participation for the same amount of money. Other incentives are generated by agreeing on a cap on the valuation, which guarantees the investor a certain minimum equity participation. Such incentives shall compensate the higher risk of the investor as debt providers (convertible loans are usually not secured), and also for the fact that the investor typically does not receive any voting rights or other rights that minority shareholders typically have. However, certain basic minority rights, including veto rights for extraordinary transactions, are commonly negotiated.
Sample legal obstacles of convertible loans
The following two sample legal obstacles show the necessity to properly set-up a convertible loan:
Convertible loans are unknown for Austrian limited liability companies
Limited liability companies (LLCs) are the most popular legal form for start-ups in Austria. The Act on Limited Liability Companies, however1, does not provide for convertible loans as instruments for investing into and financing limited liability companies. The conversion mechanics have thus to be structured “synthetically”. Such a “synthetic” structure can be achieved via an agreement between the investor on the one side and the start-up company and its shareholders on the other side. The agreement must include the obligation of all shareholders to effect, upon occurrence of the conversion event, a capital increase and to allow the investor to exclusively subscribe for the newly issued shares. It is not yet confirmed by court rulings that such agreements are fully enforceable. Furthermore, it is not entirely clear if the convertible loan agreement must be concluded in the form of an Austrian notarial deed or not. The convertible loan agreement should also provide for future changes to the start-up (eg changes of the legal form) or for changes in shareholdings (eg future shareholders must accede to the agreement).
Potential violation of the Austrian Banking Act
Granting loans (including convertible loans) on a commercial basis may require a banking licence under the Austrian Banking Act. Even one loan may qualify as commercial lending, thus requiring a banking licence. Conducting banking activities without a corresponding licence not only exposes the parties to a risk of administrative fines (up to EUR 5 million or 200 % of the benefits obtained from the unlawful activities, if such a benefit can be determined), the investor would also lose all claims for interest and costs connected with such unlawful activities, by operation of law. Convertible loans thus need to be thoroughly structured from a regulatory perspective.
Convertible loans for Austrian limited liability companies are legally feasible, but need to be thoroughly structured, in particular from a regulatory perspective to avoid legal pitfalls.