Is Your Start-up Looking for Public Money? Then Convertible Loans Might Be a Problem

Building a start-up in Germany? You'd better start thinking about funding. Bootstrapping is great until it isn't. Eventually, you'll hit that wall where you need extra money to scale, hire talent, and innovate. You've got two main paths: private money (the three Fs, angels, VCs) or public money, i.e., subsidies and grants (bonus for the latter – it is usually non-dilutive funding).

If you take the private funding route, you'll encounter one especially popular tool: Convertible Loan Agreements (CLAs). At first glance, you'll love them – speed, flexibility – what's not to like? Here's the catch: CLAs can quietly slam the door on public funding. It's like Robert Frost's poem "The Road Not Taken" – suddenly, you can't go both ways anymore. (We still believe that quoting other people makes us sound smarter than we are.)

But seriously, in this Legal Ninja Snapshot, we'll explain when CLAs can become a problem for start-ups looking for public money and how alternative structures – in particular, so-called SAFEs (Simple Agreements for Future Equity) – can help avoid these issues.

For a deep dive on CLAs and SAFE financings, we refer you to our Guides OLNS#9 – Venture Capital Deals in Germany (CLA) and OLNS#7 – Flip it Right: U.S. Holding Structures for German Start-ups (SAFE). For a comprehensive checklist of current CLA terms our separate Legal Ninja Snapshot.

1. CLAs: Every Founder's Darling?

Picture this: You're running an early-stage start-up with champagne dreams and a beer budget. You need cash to build that prototype and hire some decent developers. Sure, you could organize your first equity round. But doing so requires a full valuation of your company. Well, here's the problem: valuations take their sweet time. They also require solid data – which you simply don't have at an early stage. And don't get us started on the legal paperwork, notary fees and endless negotiations.

Enter the CLA. Basically, the CLA is a contract between the start-up and early-stage investors that functions like a loan. They provide you with money in exchange for a future participation in your company. When a triggering event occurs – usually your first or next (qualified equity) round – the loan amount (usually plus accrued interest) converts into shares. In other words, your investors pay you now and once you complete your equity round, they will own a slice of your company.

Sounds easy, right? Well, simplicity is exactly what founders like about CLAs:

• They provide quick access to capital without the hassle of an equity round.
• They require no upfront valuation; instead, valuation happens once an event, like your equity round, triggers conversion. (Well, in fact, most CLAs foresee a maximum valuation for the conversion called the "cap," and both start-up and investor need to agree on that, so there is some valuation involved after all.)
• They can be based on standardized contracts, making them relatively cheap and simple to set up.

Apart from early-stage investments, this also makes them attractive for several other time-critical scenarios:

• Bridge Financing: You're no longer running an early-stage start-up, you're already preparing for your next major equity round. If you need some additional runway to complete the process, CLAs allow current investors or new supporters to keep your operations running.
• Opportunistic Funding: An unexpected opportunity arises – a key hire becomes available, a strategic partnership requires immediate investment, or urgent R&D needs emerge. CLAs let you act fast without the delays of a full equity process.

In reality, though, CLAs get more complex than they first appear. First of all, you should take the promise of simplicity with a grain of salt, at least here in Germany. If you want to use CLAs, you have to make sure to adapt them to German law requirements. Furthermore, there's an ongoing debate about the form requirements applicable to CLAs, especially whether they require a certified signature (Beglaubigung) of the lender or, even worse, full-blown notarization (Beurkundung). Bear with us, though, because a few quirks of CLAs are paramount for you to understand when you consider seeking public money (subsidies and grants). Usually, CLAs include a maturity date and a qualified subordination clause (Qualifizierter Rangrücktritt).

• The maturity date is your deadline: If you're unfortunate and your company doesn't reach an equity round fast enough, CLAs usually contain a payback obligation to your lenders (including any accrued interest). By this, instead of a conversion, the investors can at least claim their money back.
• The qualified subordination clause is a provision that the investors will be last in line to get compensated if your company goes bankrupt. According to insolvency law, companies have to account for both their assets and their liabilities and if the assets can no longer cover the liabilities, the company will be considered over-indebted. However, if there's a qualified subordination clause, the convertible loan is not considered debt from an insolvency perspective, so it won't be counted as a liability – that's why it's so important to include it in your CLAs.

2. What's Really at Stake: Your Access to Public Funding

Obviously, the payback obligation can become a problem if the CLA reaches maturity without a conversion event having occurred before. Having a financing instrument with a (at least theoretical) future repayment obligation can create problems during the term of the CLA, namely when it comes to your public funding prospects.

We'll explain to you why that is and what the qualified subordination clause has to do with it in just a moment. But before we dive deep into legal fine print, let's quickly set the stage.

Public subsidies often come in the form of non-repayable grants that are meant to aid your company – so you can use them without diluting your stake in the company. The European and German public funding landscape is rich ("as well as complex and sometimes outright confusing," some critical contemporaries might add). Here is just a brief overview of some programs that are relevant for German start-ups:

• INVEST: allowance and taxation benefits granted to venture capital investors;
• Forschungszulage: research allowance for companies conducting R&D activities;
• GO-Bio next: for establishing life sciences companies with complex funding needs;
• EXIST-Forschungstransfer: for founding technology companies from university research; and
• ZIM (Zentrales Innovationsprogramm Mittelstand): for small and medium-sized companies conducting R&D across all technology sectors.

These grants can range from tens of thousands to over a million euros depending on your project scope and program, so don't take this lightly.

3. The Silent Subsidy Sabotage

Now, let's break down how CLAs can become a problem. The whole issue is rooted in EU law, specifically in Art. 107 and 108 of the Treaty on the Functioning of the European Union (TFEU):

• Article 107 TFEU prohibits state aid that distorts competition by giving certain companies an unfair advantage.
• Article 108 TFEU gives the European Commission enforcement powers over state aid, including the ability to order that incompatible aid be abolished.

There are certainly legitimate reasons why a state would subsidize a company apart from just giving them an unfair competitive edge. Therefore, some companies are exempt from the general prohibition via the EU's General Block Exemption Regulation (GBER). But what about your start-up – will it fall under one of these exceptions? As you might have guessed, this is where the CLAs come into play. We cannot spare you some legal technicalities here: The GBER explicitly states in Art. 1 para. 4 lit. c that its exemptions do not apply to "undertakings in difficulty".

In line with these requirements, the aforesaid public funding programs are not available if your start-up is "in difficulty". So, when is a start-up "in difficulty"?

According to Art. 2 para. 18 lit. a GBER, if you have a limited liability company (which most founders do), it is considered "in difficulty" if its accumulated losses, after deducting reserves and other equity elements, exceed half of the original share capital. Unfortunately, that's exactly the outcome a CLA can cause. It seems counterintuitive at first glance: Why would a company be an "undertaking in difficulty" if it receives investors' money? If you receive money from a CLA, doesn't this increase your capital and help your business thrive? Sure, if you take out a loan, you will be obliged to reimburse your investor in the future. But remember, at least from an insolvency law perspective, the loan provided under the CLA will not be counted as a liability if the CLA provides for a qualified subordination clause. But, unfortunately, the insolvency law perspective is not the only way to look at CLAs. There are also tax law and accounting perspectives. And they simply "ignore" the qualified subordination clause. Instead, they treat your loan as a liability. Therefore, as soon as your accumulated losses (including the CLA treated as debt) exceed your reserves and other equity by more than half of your original share capital, you're suddenly running an "undertaking in difficulty."

Let's summarize what we have just discussed: The repayment obligation of a CLA might lead to your company being considered "in difficulty" and thus no longer eligible for certain public funding due to EU law, even though it's not in actual distress and may even be doing very well.

4. Playing It SAFE (There Is No Such Thing as a Humorous Lawyer…)

So, if CLAs can become problematic, are there alternatives? And what if you have already raised one or more CLAs and now seek public funding? Can existing CLAs be amended so that your start-up is no longer an "undertaking in difficulty"?

4.1 For the Really Young Ones

First of all, even if you have used CLAs, there is a silver lining. For the first three years of their existence, small and medium-sized enterprises aren't considered "undertakings in difficulty" by the GBER unless they are actually insolvent. And that's where your qualified subordination clauses come in handy since they make sure a CLA by itself does not lead to insolvency. But, as said, this privilege has an expiration date, in that it only applies for start-ups financed by CLAs that seek public funding during their first three years of existence.

4.2 Better SAFE Than Sorry

Let us now look at SAFEs as an alternative to CLAs.

What Are SAFEs and How Are They Different From CLAs?

SAFEs were introduced by Y Combinator in 2013 to simplify early-stage fundraising and has become a popular means of fundraising for early-stage start-ups in the U.S. Using a SAFE, an investor invests cash into a company in exchange for the promise of obtaining equity upon the initial closing of the company's next equity financing. The SAFE is a simple, one-document security with terms that are generally acceptable to start-up companies and their early investors and require little to no negotiation; though, upon closer inspection, the landscape is a bit more nuanced.

Unlike a convertible note, in the U.S. a SAFE is usually not considered a debt instrument but treated as an equity instrument. Here are the main differences:

• SAFEs are not structured like loans: They don't have an interest rate or maturity date.
• The investment is converted into shares in case of a predetermined triggering event (usually an equity round or an exit).
• There is no repayment obligation (only a right to convert into shares or participate in the liquidation proceeds, as the case may be).

SAFEs therefore match the advantages of CLAs (quick process, flexibility) without the time pressure imposed by the maturity date in CLAs or the payback risk.

Remember that CLAs can turn your start-up into an "undertaking in difficulty" due to their debt-like characteristics – the money is never really "yours" since the investors can (theoretically) claim it back at the maturity date. This logic doesn't apply to SAFEs. Once you receive the SAFE investment, conversion is the only option, since payback isn't part of the deal. So you're on the 'safe' (Yes, we went there.) side.

In the U.S., SAFEs are generally considered to be more aligned with the interest and intent of a start-up company and its investors regarding their investment. Because CLAs are debt instruments, the parties must negotiate an interest rate and set a maturity date for the notes, by which time the company has to consummate an equity financing to cause the notes to convert; otherwise, the notes will become due and payable. A start-up and its CLA investors rarely consider their investment a loan to the company. Instead, they consider the investment a prepayment of the respective investor's future equity investment into the company. Due to the uncertainty of the timing that a start-up may be able to close its equity financing, both the company and its CLA investors would have to keep track of interest accrued under the CLAs and, as the case may be, extend the maturity date of such notes so that the company's next equity financing will occur before the maturity date. This is to ensure that the CLAs will convert into the company's preferred stock without becoming due and payable. The accrued interest (which, depending on the interest rate and the time a CLA remains outstanding, may be substantial) will also increase the conversion amount and result in greater dilution to the founders. In comparison, the terms for a SAFE are relatively simple and straightforward. Besides the decision whether to use a pre- or post-money SAFE template (these days, post-money SAFEs dominate), often the only items that need to be negotiated are the discount rate and/or valuation cap (plus, occasionally, the terms of a lean side letter). The post-money SAFE gets its name for the "post-money valuation cap" that sets the maximum company valuation at which the SAFE will convert into equity. Critically, "post-money" means the cap already includes the SAFE investment amount in the valuation. Hence, think of a post-money SAFE as a "reservation" for a specific slice of the company. The investor hands over cash now and locks in a guaranteed minimum ownership percentage of the company’s capitalization immediately prior to the priced round, which they'll receive as actual shares when the round closes.

Can SAFEs Be Done in Germany?

Considering all these advantages, why are SAFEs well established in the U.S. but still relatively uncommon in Germany? One key reason is that SAFEs were designed specifically for the U.S. legal environment. They can’t simply be copy-pasted into German law – there are still open questions around their tax and accounting treatment. In addition, as with convertible loan agreements (CLAs), there’s a risk of triggering unwanted tax consequences upon conversion –such as whether the claim is considered impaired at that point if the SAFE is not recognized as equity for tax purposes. Additionally, there is less practical experience with SAFEs in Germany and no widely accepted market precedents, which makes them feel more exotic and less familiar than CLAs.

That being said, we believe that German SAFE equivalents are legally permissible and can be structured in a way that they qualify as equity rather than as debt from a legal and accounting perspective.

Remember that the main difference lies in the maturity date and the payback obligation, causing the debt-like character of CLAs. If structured in an "equity-like" way, the invested capital under a SAFE will not be considered as debt. However, tax implications of the issuance and conversion of a SAFE would need to be assessed in the individual case.

Finally, these are some considerations if you wish to proceed with implementing SAFEs. (For the sake of clarity, we're going to oversimplify the technical details and focus on the key points.)

• There is similar uncertainty about form requirements applying to genuine German SAFEs (as well as the amendment of existing CLAs to resemble SAFEs). While there are good arguments that SAFEs can be set up in a way that does not require special forms, the "safest" approach (yes, we did it again) is notarization – especially if you want to change a notarized CLA to resemble a SAFE, you will have to notarize the change as well.
• Your investors might also not be too excited about giving up on a maturity date and a "classic" payback obligation as foreseen in a CLA. And what about interest rates? In the U.S., SAFEs don't bear interest. In our practice, we have sometimes come across German SAFEs with "interest-like" elements, e.g., a periodic increase of the investment amount that will eventually be converted into shares of the start-up. While we often prefer to stick to the tried and tested approach with U.S. SAFEs and keep them as simple as possible, we acknowledge that you will need to convince your investors to part with the CLA legacy structures.

5. Wrap-up

The financing tool you choose can make or break your access to public funding. CLAs are popular for their efficiency, but their debt-like nature can jeopardize your subsidy eligibility. SAFEs, on the other hand, are like the founder-friendly, generous little sibling of CLAs (well, in fact, in the United States outside of the pharma sector, SAFEs totally dominate the scene): since there's no payback obligation and no maturity date, they relieve you of that stress, and on top, they aren't considered debt. In short, they keep the funding door wide open.