Innovative start-ups and technology-orientated companies are dependent on flexible financing options. Two instruments that are frequently used in this context are the convertible loan and the subordinated loan.
Convertible and subordinated loans as common financing instruments can be attractive options for companies - but they do harbour some pitfalls in connection with public funding programmes. This article highlights what start-ups in particular should pay attention to in order not to jeopardise their eligibility for funding.
Both forms of loan are classified as mezzanine capital - a generic term for forms of financing that are located between equity and debt capital (Italian ‘mezzanine’ = ‘mezzanine floor’). Other examples of mezzanine capital are silent partnerships and profit participation certificates.
Such forms of financing can be categorised as economic equity under certain conditions. In practice, however, this is rarely the case as the necessary conditions are usually not fully met. Depending on their structure, they are categorised as either equity or debt capital in the balance sheet and explained accordingly in the notes.
Convertible loan: Equity only through conversion
A convertible loan is a hybrid form of equity and debt capital. The investor initially provides the company with a loan, which can be converted into shares at a later date - e.g. as part of a financing round. As long as the loan has not been converted, it is considered debt capital in the balance sheet - and is treated as such. The advantages are obvious: quick provision of capital, no immediate influence on the company structure and a later entry at the agreed price.
However, it becomes problematic if the convertible loan is stated as own funds in the subsidy application, although it is still legally a loan. This is because subsidising bodies generally assess the situation at the time the application is submitted. If a convertible loan is to be recognised as economic equity, the contractual conditions must be particularly carefully drafted. In particular, economic substance, risk assumption and subordination must be clearly regulated.
Subordinated loans: legally secured as equity capital
Subordinated loans are classic debt capital instruments. In the event of insolvency, the lenders are only serviced subordinated, i.e. after all other creditors. Due to this higher risk, they are often considered ‘quasi-equity’ in the balance sheet.
However, public funding organisations do not automatically accept economic equity as ‘real’ equity. The decisive factor here is the legal and not just the balance sheet valuation. Who bears what risk? Who has what rights? Such questions play a central role. A subordinated loan is therefore not recognised as an eligible equity share in many funding programmes.
The following also applies here: a subordinated loan can be regarded as economic equity if it predominantly has the characteristics of equity rather than debt capital. This is the case, for example, if it:
is permanently available,
is completely unsecured,
is actually subordinated and
the lender assumes a genuine entrepreneurial risk.
Common mistakes when combining with funding programmes
Many companies combine convertible loans and subordinated loans with public subsidies - often without realising the associated risks.
Typical mistakes are
Convertible loans are counted as equity too early.
Subordinated loans are concluded without legally ‘watertight contracts’.
Such mistakes can have serious consequences - in the worst case, funding that has already been approved has to be repaid. This has a direct impact on liquidity and can significantly damage the company's image.
Professional support should be sought at an early stage to ensure clarity:
Which funds actually qualify as eligible own funds
Which contractual and economic characteristics must be fulfilled
And how these features can have a positive impact on eligibility for funding
EurA's experts support you in designing financing instruments in line with funding requirements and recognising risks at an early stage.
Text: Boris H. Buckow
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I am part of the management team at EurA AG and am responsible for our branches in Hamburg, Kiel and Oldenburg. With many years of experience in innovation and funding consultancy, I support companies in developing and implementing strategic innovation projects – from the initial idea to successful execution. My focus lies in the precise selection of suitable funding programmes, the development of robust business models, and strategic business development. What matters most to me is working closely with our clients to create tailored solutions that are perfectly aligned with their specific business situations. I draw on over 25 years of business management expertise, which I now apply at EurA to make innovation visible and to help generate long-term success.
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