Convertible Loans (CLAs): A guide for startup founders and investors

Why convertible loans matter in early-stage funding

For innovative startups, securing early-stage funding is crucial for product development and market entry. Traditional bank loans remain largely inaccessible at this stage, making convertible loans from investors an attractive alternative. Convertible loans appear straightforward: minimal paperwork, no immediate involvement of a civil law notary, no valuation discussions yet and templates readily available online. This simplicity makes them an appealing funding mechanism for cash-conscious founders. At face value, the convertible loan appears the simplest and cheapest way of financing. But this apparent simplicity masks important complexities.

Many founders and investors underestimate the implications of CLAs. The true cost of equity only becomes clear at conversion, which can lead to unexpected dilution for founders or disappointing returns for investors. This uncertainty explains why some experienced investors avoid CLAs entirely.

CLAs typically restrict a founder’s operational freedom, with many decisions requiring lender approval during the loan period. This guide equips you with the essential knowledge to negotiate CLAs strategically, avoiding the pitfalls of generic templates that frequently favor investor interests.

After reading this guide, you will know:

• The fundamental structure and mechanics of convertible loans
• Strategic advantages of CLAs for both startups and investors
• Critical negotiation points that protect founder interests
• Key clauses and terms to master before signing any agreement

01        What Exactly Is a Convertible Loan Agreement (CLA)?

A convertible loan or CLA is a loan agreement in its core: the lender provides a cash payment under the terms of the CLA and interest accrues on the principal amount funded. After a certain amount of time, the loan will be repaid to the lender. The difference between a regular loan agreement and a convertible loan agreement is that repayment takes place by way of conversion into shares or depositary receipts of such shares at a later date – at a conversion event or trigger event. When the loan is converted into shares at such a conversion event, the company issues shares to the lender, which settles the consideration for the share issuance against its loan plus accrued and unpaid interest. In short: it’s an interest bearing pre payment for a future issuance of shares, at a valuation to be determined at the time of such issuance.

02       Common Trigger Events

The trigger events thus determine when the convertible loan is converted into shares. Reaching the maturity date of the loan is often one of those conversion events: at the end of the duration of the loan agreement, the loan (often at discretion of the investor or lender) is either repayable or convertible into shares. Another trigger event is closing a Qualified financing or Next equity financing: if a new investment round closes during the duration of the CLA, the investor is allowed to convert at the same price and at equal terms as the investors in the new investment round, sometimes with a discount (on discounts, read more below). Liquidity events or an Exit are common triggers for conversion, a Liquidity event often to be understood as a sale of the company or all or a substantial part of the assets of the company. Finally, an Event of Default is often a trigger event. An Event of Default may occur, for example, if the company fails to comply with the terms of the CLA, is declared bankrupt, ceases its business activities or changes the nature of its business.

There is not ‘one ultimate’ CLA template. CLA’s with conversion at maturity or at the time of a Qualified Financing at a valuation to be determined (or at the valuation at the Qualified Financing) are most common in practice. However, convertible loans that will always convert are becoming more popular, because they might convert at a predetermined price per share, whether or not in combination with a method to adjust the price in the interim (also called an Adjustment event). Also on the rise is the Fixed percentage convertible note: a convertible loan that upon conversion yields a fixed percentage of all shares in the company. A commonly known version of such an instrument is a SAFE.

03       Strategic Advantages of Convertible Loans

Solving the Early-Stage Valuation Challenge

Valuing early-stage companies presents inherent difficulties. Traditional methods like EBITDA multiples or discounted cash flow analyses fail to capture growth potential. With a CLA, valuation may be postponed until such a time when the start-up has already established a financial track record and has a more robust growth trajectory. In most cases, it is also possible to tie in with the valuation of a future investor (with Qualified Financing).

Tax Benefits for Investors

For the investor, the CLA provides a potential tax incentive for when the startup fails. Investors are able to write of (part of) the loan, which write-offs are often tax deductible. Until the moment of conversion, the investor qualifies as a regular creditor, which means payment before any shareholders in case of bankruptcy. Only after conversion, the lender becomes a shareholder (or holder of depositary receipts of shares).

Expedited Funding Process

Another advantage of the CLA is the speed with which it can be settled. CLAs can dramatically accelerate fundraising. The documentation primarily requires loan basics (duration, interest rate) plus robust conversion provisions, eliminating immediate notarial involvement and postponing shareholder agreement negotiations.

04       Hidden Cost Considerations

While CLAs defer certain expenses, conversion ultimately requires notarial deeds for share issuance. Conversion of several convertible loans at the same time can initiate complex negotiations around valuation, cap table calculations and shareholder rights, especially when conversion is triggered due to a Qualified Financing or when the investor pool comprises a large number of angel investors (that may have invested through sharefunding platforms).  Understanding these eventual costs and the effort it will require from the management team, remains essential for proper planning.

05       Critical Considerations for CLA Negotiations

Founders and investors should address these key points during negotiations:

Legal Requirements: Under Dutch corporate law, CLAs qualify as “rights to a future share issuance,” requiring a shareholder resolution and potentially triggering preemptive rights unless excluded. Proper documentation of a shareholder resolution (and sometimes supervisory board approvals) are legally necessary.

Template Pitfalls: Online templates may favor investor interests, particularly regarding warranties and covenants. These provisions can significantly restrict your operational freedom, requiring lender approval for even routine business decisions. Speed of governance and preventing blocking votes minority lenders, is essential to a startup, so make sure approval procedures are light and fast. Both investors and founders should be wary of these pitfalls.

Valuation Methodology: While CLAs postpone valuation discussions, they don’t eliminate them. Consider pre-agreeing on valuation approaches for conversion scenario’s outside of a qualified financing. Also consider adding cap table scenario’s so all parties involved have a clear view on the method of calculation the issue price and dilution.

Valuation Cap Considerations: Valuation caps exclusively benefit investors, potentially granting them larger equity stakes than warranted by the company’s actual value or expected, resulting in greater founder dilution. Negotiate these carefully or consider alternatives.

Series A Investor Privileges: Think ahead and be wary of the standard clause found in nearly all templates that gives the CLA holder equal rights and an equal position as a prospective Qualified Financing investor. These investors often receive significantly more favorable (financial) conditions such as liquidation preferences and down-round protections, which would in turn also apply to the CLA investor. Especially if the CLA holder receives many more shares through a Cap or a Discount than you would expect based on his deposit, a liquidation preference can cost the founder dearly. Limit it to the cash-invested amounts and, if necessary, create another (shadow) class of shares.

Employee Incentive Planning: Want to set up an employee incentive plan? Then make room for employee participation now and make sure you negotiate the ESOP or Employee incentive plan and which (current or future) shareholders will be diluted by such incentive plan.

Shareholder Agreement Strategy: Post-conversion shareholder agreements protect investor interests, but founders must also safeguard their position. Ideally, negotiate key shareholder agreement terms before finalizing the CLA to maintain leverage, as your negotiating power typically diminishes post-investment. In the case of a conversion due to a Series A funding, the negotiations for a shareholder agreement might become complex and the holder of the CLA sometimes gets a strong negotiating position.

06       Essential CLA Terms and Clauses Explained

Understanding these common provisions will strengthen your negotiating position:

Principal Amount: The investment sum, which may be provided as a lump sum, milestone-based tranches, or on-demand. Once provided, principal amounts typically become non-repayable except through conversion or at maturity. Founders should seek automatic conversion (as opposed to optional conversion) provisions where possible.

Interest Rate: Interest accumulates on the principal until conversion or repayment. Unlike conventional loans with regular payments, interest on convertible loans or notes typically compounds until conversion. Founders should negotiate simple (non-compounding) interest rates between 4-8%.

Maturity Date: The loan’s expiration date, which often triggers conversion or repayment rights. Typical periods range from one year (short) to three years (standard) to five+ years (extended).

Discount Rate: When conversion occurs during qualified financing, CLA holders typically receive a discount on the price paid by new investors, rewarding their earlier risk. Discount percentages directly impact founder dilution.

Valuation Cap: This sets a maximum company valuation for conversion calculations, increasing their return on investment. With a €5 million cap and and a fully diluted share capital of 10,000 shares or share equivalents, a €1 million CLA would yield 2,000 shares or 16.67%. In that same scenario, but with a €3 million valuation cap, the same CLA would yields 3,334 shares or 25%. The difference can be significant.

Conversion Calculation: The formula determining share price at conversion significantly impacts equity distribution. Commonly used formula for calculating the price per share is the pre-money valuation divided by the company’s fully diluted capitalization. Make sure that all parties are on the same page regarding the exact meaning of those terms; the devil is often in the details. A fixed percentage convertible is also possible, where the investor obtains a predetermined percentage of the share capital upon conversion. Yet another variant is a predetermined valuation, possibly combined with an adjustment event; an event on the basis of which the predetermined valuation is adjusted again. In any case, add cap table scenario’s to make sure everyone is on the same page.

Conversion Shares: These provisions determine what class of shares investors receive upon conversion. Typically the CLA converts into the most senior shares available upon conversion at maturity or converts into the class of shares issued in the qualified financing that triggered conversion. Founders should carefully consider implications of share classes, particularly regarding liquidation preferences (be wary of phantom liquidation preferences and liquidation preference overhangs). In the Dutch market, it is typical for angel investors to convert into depositary receipts of shares, issued by a trust foundation (STAK) that holds the shares in trust on behalf of the investors. Where the Dutch STAK structure is tax neutral (or ‘transparent’) when setup right, US based investors in Dutch companies should verify the tax implications of a trust structure.

Shareholder Agreement Provisions: Post-conversion governance requires careful planning. CLA documentation often specifies that converted investors receive “standard” minority protections, but these can vary dramatically. Be cautious about provisions granting CLA holders the same rights as later-stage investors with larger investments, as this creates disproportionate influence.

Collateral Provisions: Unlike bank financing, CLAs rarely include collateral requirements. This increases investor risk, partly explaining the higher interest rates and equity upside. While CLA holders rank ahead of shareholders in bankruptcy scenarios, unsecured creditor recovery rates typically remain minimal.

Warranties: CLA investors typically request basic warranties regarding proper company incorporation and authorization. Tech startups should expect additional intellectual property warranties confirming ownership and registration status.

Covenants: Unlike shareholders with statutory rights, CLA investors remain creditors until conversion. As creditors, they don’t have any rights regarding decision making, atleast not with added terms in convertible loan agreements. Consequently, CLAs often include covenants granting information rights to investors and approval requirements for certain corporate actions or business decisions. These operational restrictions frequently surprise founders, or are overlooked.

Most Favored Nation Clauses: to the extent that raising additional convertible loans or issuing new shares is not blocked by covenants, CLA holders sometimes ask for most favorite nation treatment, meaning they are compensated for any more favorable terms given to any subsequent lender. The most favorite nation can be limited to financial terms, such as valuation, cap, discount, but also, for example, a liquidation preference. Overly broad MFN clauses can severely limit future financing flexibility.

Expert Legal Support for Your Funding Journey

Navigating convertible loan agreements requires strategic legal guidance tailored to your specific business model and growth trajectory. Our specialized team provides comprehensive support for startup and scale-up founders and their investors throughout their funding journey, from pitch deck design to cap table modelling, to initial negotiations through conversion and beyond.

Contact INC. to discuss your specific funding needs and ensure your interests remain protected through every stage of your growth.