Convertible Loan Agreements – Legal And Tax Insights To Get It Right From The Start – Financial Services

Convertible loans have long been a flexible and popular tool for
investing in early-stage companies (start-ups). In this article, we
explore how convertible loans work, highlight their advantages and
disadvantages compared to equity financing, and address important
considerations prior to executing a convertible loan agreement. We
will clarify the complexities surrounding some of the key elements
of convertible loan agreements, such as discounts, caps, the
different conversion events and tax considerations. It should
provide founders and investors with straight-forward guidance on
this financing instrument by briefly outlining the key
considerations to make informed decisions when choosing between
convertible loans and equity financing.

1. What is a Convertible Loan?

A convertible loan is a financing instrument designed to quickly
secure cash without the complexities of an equity financing round.
An investor lends money to a start-up with the right (voluntary
conversion) or obligation (mandatory conversion) to convert the
loan into shares in the company if and when a conversion event
occurs. The determination of whether the conversion is considered a
right (voluntary conversion) or an obligation (mandatory
conversion) from the investor’s standpoint, as well as the
identification of the corresponding conversion events, are
stipulated in the convertible loan agreement and are subject to
negotiation. A conversion event can be a defined maturity date, the
occurrence of the next equity financing round or an exit
transaction.

2. What is the Incentive for a Start-Up to Enter into a
   Convertible Loan Agreement with an Investor?

Equity financing is the prevailing investment choice for
start-ups to obtain funds. For early-stage start-ups, determining
the company’s reasonable valuation is often a challenge.
Early-stage start-ups often do not have paying customers, market
traction, profits, or even revenue yet. This makes it difficult (if
not impossible) to come up with a reasonable or fitting valuation
of the company.

In the absence of a clear valuation, founders may agree on low
valuations and thus accept a high dilution of their shareholdings
in the company. The same can of course apply to investors in case
the valuation is unreasonably high. Thus, choosing a convertible
loan is advantageous if the start-up aims to delay detailed
valuation discussions. It is still paramount that the start-up and
the investor agree on specific conversion terms, which in most
cases refer to the next (qualified) financing round, exit
transaction and the maturity date of the loan.

In addition, convertible loans have proven helpful when there is
not enough time for an equity financing round and/or when a
start-up only needs to raise a small amount of funds, e.g. to
bridge a few months of liquidity between equity financing
rounds.

In conclusion, the primary incentives for start-ups (and
investors) to enter into convertible loan agreements lie mainly in
the avoidance of extensive negotiations and valuation discussions
between the start-up and the investors as well as ensuring quick
access to funds, which will be converted into equity in the near
future.

3. Key Legal Terms in Convertible Loan
   Agreements

Convertible loan agreements are governed by precise legal and
tax provisions that dictate the functionality of this financing
tool. When entering into negotiations of a convertible loan
agreement, it is crucial for both investors and start-ups to be
familiar with the relevant terminology and to understand the
consequences of certain terms and conditions.

3.1 Loan Amount and Interest Rate

The loan amount represents the funds granted to the start-up by
the investor. The loan amount can vary greatly, typically between
25’000 and a few million Swiss Francs. Convertible loans often
carry an interest rate. This rate commonly falls within the range
of 1-5%. It is important to note that the interest due is often not
paid in cash. Instead, it is converted into equity together with
the outstanding loan amount upon the occurrence of certain
conversion events.

3.2 Subordination

As a debt instrument, convertible loans will appear on the
start-up’s balance sheet as a (long-term) debt position. When a
start-up’s balance sheet indicates over-indebtedness
(Überschuldung), the start-up is in need of a subordination
(Rangrücktritt) from the lenders to prevent having to declare
bankruptcy. A subordination clause in a convertible loan agreement
is therefore a must for most start-ups. The subordination clause
stipulates that the lenders agree to subordinate their claims to
all existing and future lenders. If subordinated, (convertible)
loans are treated economically worst-case scenario of bankruptcy,
in the same priority as the shareholders. Lenders often understand
this request and accept this in exchange for the potential upside
of converting their debt into equity.

3.3 Conversion / Trigger Events

The convertible loan agreement typically defines certain events
that trigger a (voluntary or mandatory) conversion of the loan into
shares of the start-up.

Convertible loans usually have a maximum duration, known as the
maturity date. The maturity date is the date on which the loan is
due. It is the point in time when the company must repay the loan
(and accrued interest thereon, if any) if the loan has not been
converted into equity by that time. Common maturity dates range
from nine to 36 months after the execution of the convertible loan
agreement. In the absence of any earlier conversion events and in
case of a mandatory convertible loan, conversion must take place
within a specified period once the maturity date is reached
(instead of the repayment by the start-up). The conditions for such
a conversion at the maturity date are typically predetermined in
the convertible loan agreement (e.g. the valuation basis).

In addition to the maturity date, the conversion of a
convertible loan occurs in most cases during an equity financing
round. To safeguard the lender’s interests, it is sometimes
agreed that the next financing round must exceed a certain
investment threshold (so-called qualified financing round).

Therefore, upon a share capital increase in accordance with the
(qualified) financing round, any outstanding convertible loans will
convert simultaneously into shares in accordance with the terms and
conditions provided in the convertible loan agreement.

The two aforementioned triggering events are the most common
conversion events. However, there are some additional possibilities
to consider, including exit transactions and the achievement of
specific milestones.

The conversion of loans into shares involves a subscription by
way of set-off. It is important to note that, depending on the
method of the loan conversion, it may be necessary to disclose the
lenders in the articles of association of the start-up. Therefore,
it is highly recommended that both the start-up and the investors
discuss the details of the conversion mechanism prior to an
upcoming capital increase.

3.4 Valuation Cap, Valuation Floor and Discount
Rate

The valuation cap provides for a maximum limit on the valuation
of the start-up, while the valuation floor ensures there is a
minimum valuation stipulated in the convertible loan agreement.
Both have an impact on the share (or conversion) price at which the
convertible loan converts into equity at the occurrence of a
conversion event. Understandably, the valuation cap is in the
interest of the investors and provides for a capped share price.
The valuation floor on the other hand is in the interest of the
start-up and provides for a minimum share price.

The discount rate is applied to the share price paid in the
upcoming financing round by the investors of the respective
financing round; the same logic can be applied if an exit
transaction is the conversion event. Discounts are provided as a
percentage of the respective share price and typically range from
0% to 20%.

The valuation cap, valuation floor and discounts are important
parameters for the investor and the start-up. They can be combined
and should be carefully discussed.

If an investor commits to a convertible loan agreement without a
maximum valuation cap and contributes to the value growth of the
start-up, the upcoming financing round is likely to command a
higher valuation and thus a higher share price for the investor
when converting their convertible loan. This is why many investors
will want to agree on a maximum valuation cap for the conversion of
their loan.

Investing in early-stage start-ups is inherently risky. By
offering a discount on the conversion price, investors are
compensated for the higher risk they are taking by providing
capital to the company at an earlier stage of development.

Furthermore, when entering into a convertible loan agreement, an
investor contributes cash to the start-up without enjoying any
shareholder rights (until the conversion of the loan amount). They
especially have no voting and participation rights as shareholders
of the company. For these reasons investors will often seek a
discount on their share price to offset the potential risks they
are taking by investing in an early stage company. The discount on
the share price paid by future investors during a financing round
provides previous investors with a financial advantage over future
investors and thus recognizes the risks that early investors take
in this regard. Depending on the stage of the start-up and the
respective risk profile, the start-up often agrees on varying
discounts with the investor depending on the current risk profile
of the start-up.

4. Tax Considerations

4.1. Qualification as a Bond for Swiss Withholding Tax
Purposes

A loan qualifying as a bond within the meaning of the Swiss
withholding tax practices is subject to withholding, whereby the
term “bond” is defined broadly. In general, a bond
– subject to Swiss withholding tax – is a debit
instrument issued multiple times with same or similar terms for the
purpose of the collective procurement of debt. A bond exists for
Swiss withholding tax purposes whenever a loan is structured as a
bond, a medium-term note or the 10/20 non-bank rule is
satisfied:

• 10 non-bank rule: This rule is satisfied if a domestic borrower
  receives loans from more than 10 non-bank lenders (i.e. the number
  of lenders is decisive and not the number of loans) in return for
  the issuance of debt certificates at identical conditions and the
  total Ioan amounts to at least CHF 500’000. The term
  “identical conditions” is defined narrowly (i.e. in
  particular with regard to the interest rate, duration and repayment
  condition).




• 20 non-bank rule: This rule is satisfied if a domestic borrower
  receives loans on a continuous basis from more than 20 non-bank
  lenders (i.e. the number of lenders is decisive and not the number
  of loans) in return for the issuance of debt at variable conditions
  and the total Ioan amounts to at least CHF 500’000. Within the
  20 non-bank rule, any sort of debt has to be considered, except
  intragroup loans, current account payables and non-financial
  liabilities.

In addition to the aforementioned rules, the loans must be
allocated to one of the following baskets
(“basket-allocation”): i) short-term liabilities
(duration less than 12 months), ii) long-term liabilities (duration
more than 12 months), iii) guarantees / security deposit funds or
iv) current account payables. Only if the number of lenders in one
of these baskets exceed the 10/20 rule do the loans in the
respective basket qualify as a bond and trigger Swiss withholding
tax implications. Moreover, each lender is only considered
once.

4.2. Swiss Withholding Tax Implications

As long as the 10/20 non-bank rule is not satisfied and loans do
not qualify as a bond, Swiss withholding tax is not triggered,
provided that the interest yields are at arm’s length and the
thin capitalization rules (“hidden equity”) are met.
Aside from the qualification as a bond, interest payments can also
be subject to Swiss withholding tax in the light of a “benefit
in kind”. This is in particular the case if the interest rate
is not at arm’s length (safe harbour interest rates published
annually by the Swiss Federal Tax Administration)¹.

If the loans qualify as a bond, the borrower has to register
with the Swiss Federal Tax Administration, declare and pay the
Swiss withholding tax of 35% on the interest and on any discount at
the conversion of the convertible loan into shares. According to
the Swiss Withholding Tax Act, the Swiss withholding tax must be
charged to the lenders. Therefore, the borrower is required to
deduct the Swiss withholding tax from the interest payment. A
conversion discount is considered the same as such an interest
payment and therefore is subject to Swiss withholding tax. In case
Swiss withholding tax is not charged to the lender, the Swiss
withholding tax is grossed up (effective Swiss withholding tax rate
of 53.8%).

A lender residing in Switzerland is entitled to a full refund of
the Swiss withholding tax if the (gross) income is duly declared on
the tax return or duly recognized in the financial statements. A
lender domiciled abroad can only (partially) claim back the Swiss
withholding tax based on a double tax treaty.

In terms of start-up financing, the borrower often does not have
the necessary liquidity to pay the Swiss withholding tax. In
practice, the lender therefore pays the Swiss withholding tax to
the Federal Tax Administration on behalf of the borrower.

5. Income Tax Considerations

For individual lenders, interest payments and any discount at
the conversion of the convertible loan into shares are subject to
income tax. For corporate lenders, the entire income or capital
gain is subject to corporate income tax. This general rule is
applicable for convertible loans if certain exemptions are not
applicable (see section 6).

6. Exemptions: classic convertible Ioan or transparent
   convertible Ioan

Exemptions to the aforementioned tax implications are applicable
if the convertible loan qualifies either as “classic
convertible loan” or as “transparent convertible
loan”.

A conversion discount of a classic convertible loan is not
subject to income and Swiss withholding tax. The conditions for
qualification as a classic convertible Ioan are:

• Swiss issuer of the convertible loan;




• Conversion right entitles the lender to subscribe newly created
  shares of the issuer (e.g. no transfer of treasury shares);




• Issuance at par or at a premium;




• Repayment at par;




• Conversion discount of maximum 20%.

A mandatory conversion should not prevent a convertible Ioan
from being considered a classic convertible Ioan. However,
according to current tax practice, the Swiss Federal Tax
Administration recommends an advance tax ruling in order to ensure
the qualification as classic convertible loan.

Image

• 5% coupon is subject to income tax;




• If the 10/20 non-bank rule is not satisfied, the 5% coupon is
  not subject to Swiss withholding tax




• 20% discount is tax-free (no Swiss withholding and no income
  tax)

image

• The 5% coupon and the 25% discount are subject to income
  tax;




• If the 10/20 non-bank rule is satisfied, the 5% coupon and the
  25% discount are also subject to Swiss withholding tax. The
  borrower has to withhold Swiss withholding tax from the lenders and
  pay it to the Swiss Federal Tax Administration.

To summarize, a classic convertible Ioan can avoid the tax
consequences in connection with a conversion discount, even if the
10/20 non-bank rule is satisfied.

Another exemption applies if the convertible loan is
transparent. For qualification as a transparent convertible loan,
the underlying components (i.e. option / conversion right and bond)
must be separated. In practice, the different components must be
disclosed separately in the term sheet / loan agreement. If the
loan qualifies as a transparent convertible loan, the conversion
discount is subject neither to income tax nor to Swiss withholding
tax, even if the 10/20 non-bank rule is satisfied. However, given
that for start-ups comparative information is generally
unavailable, the underlying components of the bond cannot be
determined. Therefore, the transparent convertible Ioan exemption
is usually not applicable for start-ups.

Keyfacts

01 A convertible loan combines the main benefits of a loan in
terms of speed and reduced complexity with those of an equity
investment.

02 Convertible loan agreements offer start-ups a flexible and
strategic financing option, providing quick access to capital,
deferred valuation discussions, and the possibility for investor
participation in company growth. Nonetheless, careful examination
of the applicable terms is essential for both start-ups and
investors. As straightforward or “market standard” as it
may sound, convertible loan agreements can quickly be poorly
structured and misunderstood. The abovementioned key points must
therefore be carefully considered prior to executing a convertible
loan agreement. Both the start-up and the investor are thus well
advised to obtain the necessary information from the beginning.

03 When convertible loans are issued, tax implications should be
considered. With a classic convertible loan, no tax implications on
the conversion discount are triggered. Moreover, to avoid Swiss
withholding tax implications under the 10/20 non-bank rule, the
number of loans should always be monitored.

Footnotes