Convertible loans: what a business angel owns before conversion

A business angel who has signed a convertible loan owns a claim for repayment against the company, usually subordinated and unsecured, and a contractual right or duty to swap that claim for shares later. Until conversion the angel is a creditor: no shares, no vote, no line among the shareholders. How many shares the loan becomes is decided by three numbers in the agreement, the valuation cap, the discount and the interest, together with the price of a financing round that has not happened yet. That is why the holding belongs on your cap table as its own line, with its terms, and never as a percentage.

What do you own between signing and conversion?

A loan. The company owes you the principal plus interest at maturity, typically after 12 to 24 months. Almost every German Wandeldarlehen carries a qualified subordination clause, which means you may not demand repayment if doing so would make the company insolvent, and in an insolvency you rank behind all ordinary creditors. In practice the repayment claim is worth something only if the company is doing well, in which case you would rather have the shares.

What you do not own: shareholder rights. No vote at the shareholders' meeting, no statutory information rights, no pre-emption right in the next round, unless the agreement grants them. An angel with EUR 100,000 in a convertible can be the largest single financier of a young company and still learn of its round from a press release. Information rights are worth negotiating before signing; afterwards there is no lever.

The agreement also says what happens in three cases, and all three should be read before the cap is. A qualified financing round, usually defined by a minimum amount raised: the loan converts. A sale of the company before any round: conversion at the cap, or repayment with a multiple. Maturity without either: conversion at a fixed valuation, extension, or a repayment the company usually cannot afford. The third case is the common one in a slow market, and the clause for it is often the weakest in the document.

How do cap and discount turn a loan into shares?

The discount lowers the price per share you pay relative to the new investors. The valuation cap sets a maximum company valuation for computing your price. You get whichever price is lower.

Say you lend EUR 100,000 at 6% interest, with a 20% discount and a cap of EUR 5 million pre-money. Eighteen months later a round closes at EUR 8 million pre-money, with EUR 2 million of new money. The company has 100,000 shares before the round.

The round price is EUR 80 per share. With the discount your price would be EUR 64. With the cap it is EUR 5 million divided by 100,000 shares, EUR 50. The cap wins.

Your claim on the conversion date is not EUR 100,000 but EUR 109,000, because eighteen months of interest convert as well. EUR 109,000 at EUR 50 gives 2,180 shares. The new investors receive 25,000 shares for their EUR 2 million. After the round there are 127,180 shares, and you hold 1.71%. At the round price your shares are worth EUR 174,400.

With the discount alone you would have received 1,703 shares and 1.34%. With neither, 1,362 shares. The same EUR 100,000 buys between 1.1% and 1.7% of the same company depending on two clauses, and that range grows with the gap between cap and round valuation.

Three things routinely go wrong in the angel's own arithmetic. Interest is forgotten, although at 6% over two years it adds 12% to the share count. The percentage is computed on the shares before the round instead of after it. And other convertibles are ignored: if three more lenders convert in the same round, their shares dilute yours, and with a pre-money cap you cannot know your percentage until all of them are counted, along with any option pool created in the round.

How does a SAFE differ?

The SAFE, created at Y Combinator in 2013, removes the loan from the instrument. In YC's words it is not debt, bears no interest and has no maturity date. It is a right to shares in a future priced round, at a cap, a discount or both. Since 2018 the YC standard is the post-money SAFE, whose cap includes all converting SAFEs. That makes the percentage known at signing: EUR 100,000 on a EUR 5 million post-money cap is 2.0% before the new round's money, whatever other SAFEs exist.

For a German angel the practical differences are these. A SAFE has no maturity, so the awkward third case above does not arise, but neither does any claim to get money back. There is no interest and so no interest income to tax. And the document is written for a US corporation; grafted onto a GmbH it meets the same form questions as a convertible loan.

What is specific to Germany?

Form. Shares in a GmbH are created by a notarised capital increase, and under § 55 (1) GmbHG the subscription declaration requires notarial form. Whether the convertible loan agreement itself needs it has been disputed since the Higher Regional Court of Zweibrücken held on 17 May 2022 (8 U 30/19) that an agreement obliging the lender to convert was void for lack of that form. The Federal Court of Justice dismissed the complaint against that judgment on 25 April 2023 (II ZR 96/22) without deciding the form question, so there is no clarification from the highest court. Practice has drawn the cautious conclusion: where the lender is obliged to convert, the agreement goes to the notary, and the shareholder resolution authorising it as well. If you hold an older agreement with a conversion duty that was merely signed, ask a lawyer what it is worth.

Interest and tax, in outline. Interest on the loan is income from capital under § 20 (1) no. 7 EStG and for a private lender generally falls under the flat tax. There is an exception that angels meet more often than they expect: under § 32d (2) no. 1 (b) EStG the flat rate does not apply to interest a corporation pays to a shareholder who holds at least 10%, under the conditions stated there; the personal rate applies instead. When interest that is never paid out but converted into shares counts as received, and what the shares then cost for tax purposes, are questions for your tax adviser. Nothing here is tax or legal advice.

Mechanics of conversion. The claim is contributed to the company in exchange for new shares issued in a capital increase. Until that is resolved, notarised and entered in the commercial register, you are still a creditor, even if the round has been announced.

How should a convertible sit on your cap table?

As a separate line that is not yet shares. For each loan record the principal, interest rate and start date, maturity, cap and whether it is pre- or post-money, discount, the definition of a qualified round, and what happens at maturity and on a sale. Next to it keep two computed figures: the accrued claim as of today, and the shares and fully diluted percentage as if converted at the cap. The second is the upper bound of your ownership; the real figure will be at or below it.

When the conversion happens, the line is replaced by shares, with the converted claim recorded as what you paid for them and the date of the register entry. Keep the loan agreement attached to the shares it became. In five years, at an exit, someone will ask why your price per share was EUR 50 when the round was done at EUR 80.

We are adding direct holdings and cap tables to Valued this month, and the convertible was the first case that did not fit a table of shareholders. If you keep your holdings in a spreadsheet, the test is simple: pick one convertible and try to answer, from your own records alone, how many shares it becomes if a round closes tomorrow at twice the cap.