Things to know about the Valuation Cap for Convertible Loans

Founders in Germany should know these risks!

When it comes to the question of start-up financing, convertible loans come up more and more often. However, start-ups can fall into one or two traps if they are not familiar with the usual contractual mechanisms. Read on to find out what the "valuation cap" is all about and what else founders should know.

Convertible loans? What it's all about...

First things first: What is a convertible loan? An investor gives a company, usually a start-up, a certain amount of money as a loan. The special thing about it is that after a certain period of time the lender can choose whether to have the money paid back or whether he prefers to exchange it for shares in the company.

You can also find out more about convertible loans on our website: https://www.rosepartner.de/en/lawyer-germany-wandeldarlehen-startup-convertable-loan.html

Pros & cons: convertible loans for start-up financing in Germany

There are many reasons in favour of a convertible loan as a financing option:

1. deferring the often difficult question of the right valuation of a start-up
2. start-up gains money quickly and easily
3. security for the investors: money back with interest or shares in the start-up
4. risk compensation for the early investment through a valuation discount in the share calculation
5. convertible loans are generally free of formalities; there is no need to go to a notary.

However, these advantages also entail risks. Due to the lack of a notary's visit, founders often sign contracts without actually being aware of their implications.

How many shares does the investor receive with a valuation cap?

If the investor finally decides to buy the shares, the question inevitably arises: How many shares will the investor get (at most) for his investment? In this context, the valuation cap becomes relevant. It limits the maximum valuation of the start-up for the share calculation when converting a convertible loan into shares to a certain amount right from the start.

As a result, however, the great advantage of convertible loans, namely the deferral of the valuation of the start-up, is not only cancelled out, but in practice usually even undermined. Regardless of the actual or expected value of the start-up, a - often very low - value per share is already set for the investors here for the conversion.

After convertible loan: Share calculation with valuation cap in german practice

The effects of the valuation cap become clear in the following calculation example:

• Shares for investor = loan amount (D) / (value per share (W) x valuation discount (B)).
• For the calculation, the value of the company, i.e. the value per share, is limited to a certain sum. Here: EUR 5,000,000.
• With a share capital of EUR 25,000, the value per share (W) is then a maximum of EUR 200.
• The valuation discount (B) is 0.8.
• With a loan amount of EUR 500,000, the investor is then entitled to about 3,125 shares, i.e. about 12.5% of the company.

If the actual value of the company is EUR 50,000,000 afterwards, the lender would actually (i.e.: without the valuation cap) be entitled to only 312.5 shares, i.e. only 1.25% of the company. Due to the valuation cap, however, the investor has already been assured shares at a much lower value.

Convertible loan should be prepared in advance by german founders

Although founders can save themselves the trouble of going to the notary with a convertible loan, they should be all the more attentive when it comes to transferring shares in their start-up. If you have already considered the potential value of your company, you won't look stupid afterwards when you lose more shares than you would like.

If you need legal advice in connection with the valuation of start-ups, the lawyers of ROSE & PARTNER, in particular our corporate lawyers, will be happy to assist you. For more information, please visit our website: https://www.rosepartner.de/en/lawfirm-germany/startup-company-valuation.html