Convertible Loans in Venture Capital.

A founder team needs capital, but has neither meaningful revenues nor a finished product. An investor is willing to provide money, but does not want to lock in a valuation that may prove wrong six months later. The solution the parties regularly choose in that situation is a convertible loan (Wandeldarlehen; in the US context often a convertible note). The investor grants a loan to the startup which is later not repaid, but converted into shares in the company. The valuation question is pushed back to a point in time when there are more reliable data points and, usually, larger investors are prepared to commit to a valuation.

This article explains how convertible loans work, which clauses form their economic core and where the typical drafting pitfalls lie.

Quick Overview

Point	Typical structure	What to watch
Conversion trigger	qualified financing, maturity or exit	define minimum volume, internal rounds and control rights clearly
Pricing logic	discount, cap or the mechanism more favourable to the investor	define pre-money/post-money cap and company capitalisation expressly
Term	often 18 to 36 months	do not leave the no-financing scenario open
Form	agreement usually signed privately, capital increase later notarised	review mandatory conversion and accession to notarisation-requiring documents separately
Risk layer	tax, insolvency, regulatory law	align subordination, interest and impaired-claim conversion early

Why use a convertible loan instead of a direct equity investment?

Convertible loans are the preferred instrument for early-stage financings for several reasons:

• Significantly lower transaction costs. A convertible loan agreement typically runs to 10–15 pages. Full equity financing documentation with an investment agreement, shareholders’ agreement and ancillary documents easily reaches 50–100 pages, requires notarisation and triggers corresponding notarial and advisory costs. Our notary fee calculator gives an initial indication of the notary costs of an equity round.
• Flexible fundraising over a longer period. Unlike an equity round, where all investors subscribe on the same day at the same price and funds only flow once the round is closed, convertible loans can be entered into successively. This makes it possible to collect smaller amounts over several weeks or months without having to negotiate the entire round in advance. Cap and discount can also be adjusted from one loan to the next as the equity round comes closer.
• The valuation is postponed. The valuation question is deferred to the next priced financing round. The lender is then put in the position as if it had invested in that round, but on better terms to compensate for the higher risk of investing earlier.

From the investor’s perspective, the convertible loan is a pragmatic way to deploy capital quickly. From the founders’ perspective, the cap table initially remains formally unchanged, no governance rights arise and the administrative burden is low; economically, however, dilution potential is already created.

Core clauses in a convertible loan agreement

Discount

The discount is the price reduction the lender receives on conversion compared with the new equity investors in the financing round. Discounts of 15–25% are common, depending on the risk profile and the expected time until the next round.

Example (simplified): the next equity round sets a price of EUR 1,000 per share. With a 20% discount, the lender converts at an effective price of EUR 800 per share and therefore receives more shares for the same amount invested. The actual price per share also depends on the agreed conversion method.

The discount compensates for the risk of the earlier investment, but it has a weakness: if the valuation rises sharply between the convertible loan and the financing round, a discount alone is often not enough to reflect the return advantage of entering early. That is where the cap comes in.

Valuation cap

The cap (valuation cap) limits the valuation at which the convertible loan converts, regardless of how high the actual valuation in the next round turns out to be. The cap protects the early investor against two scenarios: first, where the valuation rises so strongly that the discount no longer compensates adequately for the early entry; and second, in the less common case where the financing round does not produce a genuinely market-negotiated valuation.

Example: cap of EUR 5 million. The Seed round values the company at EUR 15 million pre-money. The lender converts on the basis of EUR 5 million, not EUR 15 million.

From the founders’ perspective, the cap is the point at which the economic effect of a convertible loan becomes most visible. The lower the cap relative to the later valuation, the more shares the lender receives on conversion.

Pre-money cap vs. post-money cap

A frequently overlooked but economically important distinction concerns whether the shares created from the conversion of all outstanding convertible loans are already counted when calculating the conversion price. Put differently: is the conversion price calculated by dividing the cap by the existing shares, or by the existing shares plus the conversion shares? In the second case, the price per share is lower and the lender receives more shares.

• Pre-money cap: the conversion price is calculated as cap ÷ existing shares (excluding the conversion shares). If several convertible loans are outstanding, the individual lender’s stake in the logical second between conversion and dilution by the equity round is not fixed from the outset, because the conversion shares of the other lenders affect its own percentage. In German practice, pre-money caps are therefore often paired with an agreed aggregate ceiling for all convertible loans, so that the total number of conversion shares does not remain entirely open.
• Post-money cap: the conversion price is calculated as cap ÷ existing shares (including all conversion shares). This makes it possible to derive the lender’s percentage immediately after conversion: loan amount ÷ post-money cap = percentage (subject to the contractually defined company capitalisation, in particular ESOP/pool rules). This is more transparent for the lender, but usually more dilutive for the founders.

The choice between a pre-money and a post-money cap also depends on how the convertible round is structured. If SAFEs or convertible loans are understood as a distinct round in their own right (the typical US post-money SAFE logic: this is the Seed round), the mechanics differ from a case where money is being collected in advance of a planned equity round. In German practice, pre-money caps remain more common; in the US market, post-money caps have become the standard. The choice becomes particularly relevant once several convertible loans are outstanding before a round, because the conversion shares of the other lenders then affect one’s own conversion price. Our cap table simulator makes these differences visible.

Another point that regularly causes misunderstandings in practice is whether existing ESOP/VSOP pools and any planned top-up in the equity round are taken into account when calculating the conversion price. If the pool shares sit in the denominator, the conversion price drops and the lender receives more shares. Many convertible loan agreements do not address this point clearly enough, or the parties do not fully understand the effects. The result is surprise at conversion, when an ESOP top-up suddenly changes the numbers. The agreement should therefore expressly define which pools (existing and planned) are included in the company capitalisation.

Discount and cap together

In German practice, most convertible loans contain both a discount and a cap. On conversion, the more favourable mechanism for the investor applies, i.e. the lower effective price per share.

Example: cap of EUR 5 million, discount of 20%. The Seed round values the company at EUR 8 million pre-money.

• Price based on the cap: calculated on a EUR 5 million valuation
• Price based on the discount: 80% of the Seed price (effectively a EUR 6.4 million valuation)
• Result: the cap applies, because EUR 5 million < EUR 6.4 million.

If the Seed valuation were EUR 4 million, the discount would instead be more favourable (EUR 3.2 million < EUR 5 million). In that case, the cap would not bite.

The cap table simulator allows the pricing logic to be switched for each individual convertible loan so that the effects can be compared.

MFN clause and pro rata right

Where several convertible loans are entered into successively, early lenders will ask whether later investors may receive better terms (lower cap, higher discount). A most favoured nation clause (MFN) gives the early lender the right to align its terms with the best later convertible loan.

In addition, many convertible loan agreements include a pro rata right: the lender may invest additional fresh capital in the qualified financing round alongside the converting amount in order to maintain its percentage. In the YC SAFE, this is standardised as a pro rata side letter. In German practice, it is less often handled as a separate document and more often agreed as a clause in the convertible loan agreement itself.

Two qualifications are frequently negotiated in practice: MFN clauses often do not cover all ancillary rights automatically, but only defined economic terms (cap, discount, interest). And pro rata rights are in many structures limited to major investors above a minimum investment threshold or made subject to allocation decisions of the lead investor in the equity round.

Conversion right and mandatory conversion

A central question that is often overlooked is: who can require conversion?

• Conversion right of the lender. The investor may convert, but does not have to. It retains the option, in an adverse scenario, to insist on repayment (to the extent the qualified subordination permits this in practice).
• Mandatory conversion for the lender. Upon specified events (typically a qualified financing round), the investor must convert. From the startup’s perspective, this is advantageous because the debt is then safely eliminated. From the investor’s perspective, mandatory conversion can be problematic if the round takes place on terms the investor cannot itself influence.
• Conversion right of the company. In some structures, the company itself also has the right to trigger conversion, typically at maturity.

In practice, conversion rights and mandatory conversion mechanics are often combined. The exact drafting determines who controls the timing and the terms of conversion when it matters.

Qualified financing round

The qualified financing round is the event that triggers conversion (where conversion is mandatory) or gives one of the parties the right to convert. It is typically defined as an equity financing round above a minimum volume, for example EUR 500,000 or EUR 1 million.

That definition serves an important purpose: it is intended to ensure that the conversion price is based on a valuation that was actually negotiated in the market. For that reason, many convertible loan agreements also provide that the round must not be purely internal (in other words, not a round in which only existing shareholders participate).

Term and maturity

Convertible loans have a fixed term, typically 18–36 months. If the term expires without a qualified financing round having taken place, the next question is obvious: what happens then?

Common solutions are:

• Conversion at a maturity-cap valuation. The loan converts into equity at an agreed valuation, often the cap.
• Repayment. The investor may call for repayment. In practice, however, this is of limited value where the loan is subject to qualified subordination, because the subordination restricts enforceability.
• Extension. The term is extended by agreement.

A separate issue that should always be addressed is an early exit (sale of the company or IPO) before maturity. It is common for the lender either to convert in advance or to receive a minimum repayment amount (typically a multiple of the loan amount). This clause is often overlooked, but economically important for both sides.

Interest

From a legal perspective, convertible loans are still loans within the meaning of § 488 BGB. In practice, interest rates between 0% and 10% p.a. are used. A 0% interest rate is also possible, especially where the parties want to approximate a SAFE-style structure; in that case, the lender’s economic upside comes exclusively from cap and discount. Where interest is agreed, it is usually not paid currently, but added to the loan amount and converted together with it.

Caution: the tax treatment of interest upon conversion is not straightforward. Depending on the structure, the company may have withholding obligations for German capital gains withholding tax. The details depend on the specific case and should be coordinated early with the tax adviser.

Accession to the financing documents

A point often underestimated at signing is the legal position into which the lender converts. Most convertible loan agreements provide that, upon conversion, the lender accedes to the existing or newly executed shareholders’ agreement. The question is whether it receives the same rights and obligations as the new equity investors in the round, or whether a separate share class or different terms apply. In particular, the question whether the lender falls into the same liquidation preference-stack as the equity investors has a noticeable economic impact and should at least be addressed in principle in the convertible loan agreement.

Who bears the dilution from conversion?

The way a convertible loan is translated into shares has a major impact on the resulting percentage holdings. The central question is: who bears the dilution caused by conversion?

At bottom, this is about whether the convertible loan is treated economically as part of the priced equity round now taking place (in which case conversion also dilutes the new equity investors), or whether the conversion is already built into the pre-money base before that round (in which case the new equity investors’ percentage remains fixed). There are several pricing logics for allocating dilution. In practice, two models matter most; negotiated hybrids are possible in between.

Everyone is diluted proportionally

The price per share is calculated by dividing the pre-money valuation by the existing shares (excluding the conversion shares). Conversion then creates additional shares that dilute everyone proportionally – including the new equity investors. The new equity investors therefore receive slightly fewer shares for their money than the headline valuation suggests. This model fits the view that the convertible loan and the equity investment are economically part of a single round.

Only the existing shareholders bear the dilution

The pre-money valuation is understood on a fully diluted basis, i.e. including the conversion shares. The new equity investors therefore pay a lower price per share that already factors in the conversion. Their percentage (investment ÷ post-money) remains fixed; the dilution from conversion is borne exclusively by the existing shareholders.

In term sheets, this variant is often recognised by wording such as “The pre-money valuation is on a fully diluted basis” or “Outstanding convertible instruments are taken into account when calculating the pre-money valuation.” This model treats the convertible loan more like financing that has already been accounted for before the equity round.

Caution: “fully diluted” is not defined uniformly in practice. What matters is whether the conversion shares are included in the share count used to calculate the issue price.

Hybrid solutions

In practice, these two models are not always applied in pure form. A common hybrid is that the loan amount itself (possibly including accrued interest) dilutes everyone, while the pricing advantage generated by the cap or discount is borne solely by the existing shareholders. The result lies somewhere between the two main models. Such compromises are particularly common where the negotiating leverage of the existing shareholders and the new equity investors does not permit a clear allocation in one direction.

Why the method is a matter of negotiation

The differences between these models can move the percentage holding of the existing shareholders by several points. Our cap table simulator calculates several variants in parallel so that the effects can be compared directly.

For the equity round term sheet, the headline valuation alone is therefore not enough. It should make clear whether the pre-money valuation is meant on a fully diluted basis and which conversion shares, option-pool increases or other instruments are included in the share base. In practice, the parties should align on a cap table when agreeing the term sheet, even if the final technical implementation is documented later in the financing documents.

Corporate implementation of the conversion

The convertible loan agreement regulates the economic terms of conversion. In a GmbH, the corporate implementation requires a number of additional formal steps: a capital increase resolution of the shareholders’ meeting, the lender’s subscription declaration for the new shares and the filing with the commercial register.

In practice, the conversion is usually implemented as a cash capital increase, not as a contribution in kind. The lender pays in the cash contribution on the new shares and, separately, assigns its repayment claim under the loan (including accrued interest) to the company as a contractual share premium. Because debtor and creditor then merge in one person, the claim is extinguished by confusion (Konfusion). The nominal amount of the newly subscribed shares increases the share capital; the excess amount is booked to the company’s free capital reserve under § 272 para. 2 no. 4 HGB.

The advantage of this structure over a contribution-in-kind capital increase is that the capital increase resolution does not have to specify a contribution in kind, and the valuation of the loan claim does not become visible externally through the commercial register.

In the contractual drafting, one must secure not only the price formula, but also the future implementation of the capital measure. That includes, in particular, whether the shareholders authorise management in advance to carry out the capital increase (where appropriate through authorised capital under § 55a GmbHG) and whether the existing shareholders commit in advance to cooperate so that the necessary three-quarter majority is available.

Notarisation requirement: the open flank

Whether a convertible loan agreement itself must be notarised remains one of the unresolved formal questions in German corporate practice. For a long time, the prevailing practical assumption was that convertible loans could be entered into without notarisation as purely contractual agreements and that the notarisation requirement only arose at the actual conversion stage (capital increase resolution and subscription declaration).

The Higher Regional Court of Zweibrücken (judgment of 17 May 2022, case no. 8 U 30/19) cast doubt on that assumption. Its key statements were:

• If the convertible loan contains a mandatory conversion obligation of the lender (rather than merely a conversion right), the subscriber’s signature requires notarised certification under § 55 para. 1 GmbHG at least where the investor is not already a shareholder.
• If the agreement grants the company a unilateral conversion option which, when exercised, leads to a capital increase that amends the articles of association, the court considered that there were strong arguments for a notarisation requirement under § 53 para. 2 GmbHG.

The practical consequence in the decided case was drastic: the insolvency administrator argued that the form-invalid convertible loan had from the outset created an enforceable repayment claim and had therefore brought forward the duty to file for insolvency. The court agreed; the managing directors were held personally liable.

In the appeal proceedings before the Federal Court of Justice (order of 25 April 2023, case no. II ZR 96/22), the court did not have to decide the formal issue as a decisive ground. It did, however, expressly note that the legal view of the Higher Regional Court of Zweibrücken found no support either in other higher-court case law or in the majority of the legal literature. It is therefore quite possible that the Federal Court of Justice would ultimately take a less strict line. The issue, however, remains unresolved to this day.

For practice, this means the following: notarisation is clearly required where the convertible loan combines a mandatory conversion with an obligation to accede to a shareholders’ agreement that itself contains provisions requiring notarisation (in particular drag-along or co-sale transfer obligations). In all other constellations, a residual form risk remains and should be addressed consciously in drafting.

Tax treatment

The tax treatment of convertible loans is less clear-cut than it appears at first glance.

Is conversion a tax-neutral event?

Under the view that has so far largely prevailed, and according to coordinated administrative guidance, the conversion of a loan into shares is not in itself a taxable event for the investor. Economically, it is treated as a contribution of the loan into equity. In 2018, the heads of the state income tax departments confirmed in coordinated short guidance that the previous tax-neutral treatment should continue. Before that, some state tax authorities had tried to characterise conversion as a swap-like realisation event. If that view had prevailed, the advantage generated by the discount or cap (i.e. the difference between the value of the loan claim given up and the fair market value of the shares received) would have been taxable at investor level. That approach did not prevail; however, the issue has still not been definitively resolved by the highest courts.

Taxable income if the converted claim is impaired

One tax-sensitive point becomes relevant whenever the loan claim contributed on conversion is not fully recoverable in value at the conversion date: to the extent that the converted loan amount exceeds the actual value of the shares received, the company may realise taxable income. The impaired portion of the contributed claim is then not treated as a contribution, but as income. This risk arises particularly in startups that have performed worse than expected and where conversion occurs not in a financing round with a third-party valuation, but at maturity or in a distressed situation. The resulting tax burden can create real liquidity pressure at precisely the wrong moment.

Interest

From a tax perspective, the interest component is particularly sensitive. Whether, and to what extent, German withholding tax on capital income must be withheld and remitted when accrued interest is converted depends heavily on the structure and on the lender’s status (in particular: individual or corporate entity, domestic or foreign, shareholder or third party). The details are highly fact-specific and should be discussed with the tax adviser before the agreement is entered into.

Insolvency and regulatory law: qualified subordination

In practice, German convertible loans regularly contain a qualified subordination clause combined with a pre-insolvency enforcement block. The reason is straightforward: without subordination, the loan liability could trigger over-indebtedness not only at maturity, but already when the liability is incurred. If properly drafted, the qualified subordination has the effect that the claim is not taken into account as a liability causing over-indebtedness in the insolvency over-indebtedness status. In addition, qualified subordination serves to reduce regulatory risk: without it, the unconditional repayment obligation may qualify as a deposit-taking business under the German Banking Act (KWG).

For investors, that means qualified subordination is not a concession, but a protective device for the company which indirectly protects the investment as well. For founder-managing directors, it is essential because, without subordination, personal liability risks for delayed insolvency filings can arise – as the Zweibrücken case illustrates rather vividly.

From a regulatory perspective, this does not mean that every convertible loan requires a licence. The risk increases, however, where funds are accepted with an unconditional repayment claim, especially outside a narrow shareholder or investor circle or through standardised offerings. An effective qualified subordination can remove the unconditional nature of the repayment claim, but the wording must be precise enough to work for both insolvency and regulatory purposes.

Common mistakes and drafting traps

1. A cap needs its own definition. Whether the cap is pre-money or post-money, whether ESOP pools are included, whether other convertible loans are taken into account when calculating the conversion price – all of this materially affects the conversion price and must be defined clearly in the agreement.
2. Conversion method not addressed. Unlike cap and discount, the conversion method usually cannot be fixed conclusively in the convertible loan agreement, because the equity investors in the next round still have to agree to the financing structure. In practice, the method is therefore negotiated in the term sheet and in the equity round documents themselves. What matters is that the issue is addressed early; if there is no clear approach, the conflict between existing shareholders, lenders and new investors is effectively built in.
3. Maturity provisions too short-sighted. What happens if there is no qualified financing by maturity? What if there is an early exit? What if the company can neither convert nor repay? All three scenarios should be covered. The tax effects of a conversion at maturity, in particular the possible taxable income where the claim is impaired, should also be considered early.
4. Ignoring the notarisation issue. If the convertible loan contains a mandatory conversion or an obligation to accede to a shareholders’ agreement containing notarisation-requiring provisions, there is a real risk of form invalidity with significant personal liability consequences for the managing directors.
5. Tax effects of conversion not considered. Conversion is often seen as a purely corporate step. The tax consequences, however – taxable income on an impaired claim, withholding tax on interest, accounting classification – can be substantial and should be clarified before the loan is entered into.
6. Treating subordination as boilerplate. A qualified subordination clause must work for insolvency and regulatory purposes. Ambiguous wording may, in the worst case, fail both to relieve the over-indebtedness analysis and to reduce the KWG risk sufficiently.
7. Accession terms and share class left open. On what terms does the lender accede to the shareholders’ agreement? Does it receive the same share class and the same rights as the equity investors in the round? In particular, the lender’s place in the liquidation preference stack is often not thought through early enough.

Convertible loan vs. SAFE

In the US startup and VC market, the SAFE (Simple Agreement for Future Equity) has largely replaced the convertible note. The main difference: a SAFE is an equity-like instrument without maturity, without interest and without a repayment claim. Economically, it works in a similar way (discount, cap, conversion on a qualified financing), but the legal classification is different.

In Germany, the SAFE is not yet the standard, but it is being discussed more often and is used in individual pre-seed and internationally influenced financings. Founders and investors with a US or accelerator background in particular like the idea: no classic debt instrument, no fixed maturity, no running interest and no repayment claim.

Its legal characterisation (equity? profit participation right? subscription arrangement? other contractual acquisition right?) has not been definitively clarified, and both the tax and accounting treatment raise questions that remain unresolved in the absence of highest court case law. In addition, the automatic conversion of a US SAFE does not fit neatly into the GmbH framework, because issuing new shares requires a shareholder resolution, subscription declarations and notarial involvement. For that reason, German early-stage financings still rely predominantly on convertible loans; SAFE-like instruments are a deliberately structured alternative rather than a simple replacement.

When a convertible loan makes sense

• Pre-seed and early Seed stage. Where a reliable valuation is not yet possible or sensible, and the transaction costs of a full equity round would be disproportionate to the amount being raised.
• Bridge financing. Between two financing rounds, in order to bridge the gap until the next round.
• Successive fundraising. Where several smaller amounts are to be raised from different investors over time, without everyone having to sign simultaneously.

At a certain point – in Germany often already at Seed stage, but typically by Series A at the latest – the market will move to a priced equity round. Investors then expect a clear shareholder position with information and governance rights, and the valuation question can be answered on the basis of more reliable metrics.

When a convertible loan is the wrong choice

As pragmatic as the instrument is, it does not fit every situation. A convertible loan is the wrong choice where a robust valuation is already emerging: once a lead investor has put a valuation on the table, a priced round is usually the cleaner route, because it immediately creates clear ownership, share classes and governance rights. The logic can also flip for larger amounts: the higher the sum, the more strongly cap and discount drive later dilution – beyond a certain volume, a properly negotiated valuation can be cheaper for the founders than the supposedly quick bridge.

A second case is the investor who needs real shareholder rights from the outset – governance, information or control rights. Those arise only on conversion; anyone who wants them immediately is better served by a direct equity investment. Finally, the instrument is delicate in a crisis: if a loan whose claim is no longer fully recoverable converts, the company may recognise taxable income, and an imprecise subordination shifts the liability risk onto the managing directors (on the regulatory side, see Lending and the KWG licence).

In short: the convertible loan is a tool for the phase of genuine valuation uncertainty – not for the round that could already be priced.

Anyone who wants to model the economic effect of a convertible loan on the ownership structure in concrete terms will find a useful tool in our cap table simulator, which maps cap, discount, interest and several conversion methods. And for the question how exit proceeds are distributed after conversion, the liquidation preference calculator is a useful next step.