27.04.2022, English Articles

Valuation cap in convertible loans

Attention: Trap for founders of startups!

An article by Fiona Schönbohm, lawyer for corporate law in Hamburg and Berlin 

Convertible loans as a financing option have recently become very popular, especially among startups. However, founders should familiarize themselves with the common contractual mechanisms in order to avoid traps by investors. Especially the so-called "Valuation Cap". You can find out everything you need to know in this article. 

What is a convertible loan? 

A short digression at the beginning: What is a convertible loan? Well, with a convertible loan, a company, usually a startup, is initially granted a certain amount of money as a loan (colloquially: a credit). 

The special feature: After a certain period of time, the lender can decide whether he wants to get the money back or whether he prefers to exchange it for shares in the company. 

Advantages and risks of the convertible loan 

There are many reasons for the attractiveness of the convertible loan as a financing option: 

  1. The often difficult question of the correct valuation of a startup is postponed. 
  2. Quick and uncomplicated money for the startup.
  3. Security for the investors: money back with interest or shares if the startup develops positively. 
  4. Risk compensation for early investment through a valuation discount in the share calculation. 
  5. Basically freedom from formalities: contract directly with the investor, no need to go to a notary.

But be aware: These advantages also entail risks. Not going to a notary leads to founders signing contracts without actually being aware of their implications.

The question it comes down to is in the end: How many shares does the investor get (at most) for his investment? The so-called valuation cap plays a special role here. 

Valuation Cap: What is it? 

With a so-called Valuation Cap, the maximum valuation of the startup for the share calculation when converting a convertible loan into shares is limited to a certain amount from the beginning. 

This not only relativizes the great advantage No. 1 of convertible loans, the postponement of the valuation of the startup, but in practice usually turns it into its opposite: Regardless of the actual or expected value of the startup, a - often very low - value per share is already determined for the investors for the conversion.

Calculation of shares with valuation cap

Let's illustrate the effects of the Valuation Cap with 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 amount. Here: 5million EUR. 
  • With a share capital of 25,000 EUR, the value per share (W) is therefore a maximum of 200 EUR. 
  • The valuation discount (B) is 0.8.
  • With a loan amount of 500,000 EUR, the investor is then entitled to around 3,125 shares, i.e. around 12.5% of the company.

If the actual value of the company is later EUR 50million, the investor 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 received shares at a much lower value. 

Conclusion: Knowing the company valuation is key!

When transferring shares at the notary, for example in venture capital investments, founders are usually aware of what they are giving up and at what price.

In the case of a convertible loan, on the other hand, startups often sign over a large part of their shares at an already fixed sum without being aware of it or, to a similar extent as in the case of a venture capital investment, dealing in advance with the actual or potential value of their company.

Anyone who wants to take out a convertible loan should inform themselves in advance about the basics of startup company valuation and be aware of the value of their own company before rashly signing a convertible loan agreement - even if it looks so simple.