Term definition: Convertible
The term Convertible comes from English and means “convertible”. In a legal context, a convertible describes a financial instrument that grants the holder the right to convert it into another legal position. The most common form in legal practice is the so-called convertible loan (English: “Convertible Loan” or “Convertible Bond”), which is of significant importance especially in the financing of companies, such as start-ups.
Legal classification of the convertible
General overview
A convertible is a hybrid financing instrument that exhibits typical characteristics of both equity and debt capital. It is usually a loan that can be converted into shares (for example, stocks or company shares) of a company in accordance with an agreement. This convertibility is the defining feature of a convertible and distinguishes it from classical loan types.
Convertible loan under German law
Legally, the convertible loan is structured as a civil law loan agreement (§§ 488 ff. BGB), which provides an option or even an obligation to convert the loan claim into company shares. The details of the conversion are regularly governed by a separate conversion agreement.
Civil law basis
The civil law structure of the convertible, as far as it concerns the debt component, is based on the provisions of the German Civil Code (BGB) on loan law. The conversion mechanism, on the other hand, is typically established as a contractual option, whereby both the conditions and the conversion rate or valuation methods can be freely agreed upon, as long as they do not violate mandatory law or applicable corporate regulations.
Corporate law aspects
When the conversion option is exercised, the lender becomes a shareholder. Under German law, this may be subject to different rules depending on the legal form:
- GmbH: The issuance of new company shares requires notarized shareholder resolutions and registration in the commercial register (§ 55 para. 1 GmbHG).
- AG: The issuance of shares as part of a conversion is often linked to authorized capital (§ 202 ff. AktG) or conditional capital (§ 192 ff. AktG). The general meeting must pass the necessary resolutions for this.
The design of the conversion mechanism is influenced by company law, particularly with regard to co-management rights, pre-emptive rights of existing shareholders, and capital maintenance principles.
Tax aspects
For the tax treatment of convertible instruments, a distinction must be made between the loan and the equity portion. The interest income from the convertible is treated as investment income or business income during the loan period. Upon conversion, the valuation of the shares plays a central role — both for the purposes of trade tax and income tax contribution value. The taxation of any capital gains after the conversion is governed by the general rules for the taxation of disposals of shares.
Insolvency-specific classification
In the event of insolvency, it must be determined whether the convertible is classified as debt or equity. During the loan phase, the creditor is entitled to a repayment claim, which can be filed in the insolvency table in the event of insolvency. After conversion into shares, the former lender participates in the company’s assets only subordinately as a shareholder.
Contents of regulations and typical contract clauses
Conversion conditions
Contracts on convertible instruments regularly cover the following regulatory aspects:
- Conversion date: Determination of the point in time or the occurrence of certain events at which a conversion can or should take place (e.g., next financing round, specific cut-off date, exit event).
- Conversion ratio or conversion price: Specification of the conditions (company valuation, e.g., discount compared to investors in the follow-up financing round) under which the loan amount is converted into shares.
- Obligations to cooperate: Provisions regarding the cooperation of the company and other shareholders in carrying out the conversion.
- Waiver of repayment claim: It is sometimes agreed that, after conversion, the investor’s repayment claim against the company lapses.
Further contract provisions
- Interest agreements: Specification of an interest rate for the duration until conversion.
- Subordination: Provisions on ranking in the event of insolvency.
- Prohibition of early repayment: Provisions that an early repayment is not possible or only possible under certain conditions.
- Anti-dilution clauses: Protection of the convertible holder against economic disadvantages in the case of later capital measures (“Anti-Dilution Protection”).
Areas of application and functions of convertibles
Corporate financing
Convertibles are primarily used to finance young companies (start-ups) in order to provide capital at an early stage without having to determine a company valuation immediately. The valuation is usually postponed and takes place during the next financing round.
Listed bonds
Convertible bonds represent an exchange-traded form of the convertible. They are structured in accordance with the requirements of stock exchange and securities trading law and regularly include specific regulations on investor protection, prospectus obligations, and disclosure requirements under the relevant financial market rules.
International legal framework
Convertibles are also widespread internationally. In many jurisdictions, comparable regulations apply with regard to the conversion process and corporate law integration. Differences often arise in terms of shareholder protection, disclosure requirements, or tax treatment.
European legal framework
Within the European Union, harmonized regulations exist for prospectus obligations and market abuse provisions, which may be relevant for convertible bonds. Corporate law requirements, particularly regarding capital protection, are also regulated at the EU level.
Conclusion
The term Convertible describes, in a legal context, a customizable, hybrid financing instrument that plays an important bridging role between debt and equity capital. Its legal structure requires careful consideration of corporate, civil, tax, and insolvency law requirements. Convertibles are gaining increasing importance, particularly in corporate financing and capital markets law, and — depending on the company’s legal form — must be customized in accordance with existing legal regulations.
Frequently asked questions
What are the legal requirements for the structuring and documentation of a convertible?
When structuring and documenting a convertible, particularly in Germany, numerous legal requirements must be observed. First, the agreement between the parties must be in the form of a written convertible loan agreement that clearly regulates the essential rights and obligations. In this context, the terms for conversion, the valuation at conversion, interest, and durations must be documented in detail. In certain cases, such as when participation rights or debentures are publicly offered, additional prospectus obligations under the Securities Prospectus Act (WpPG) must be checked. The design of the conversion rights should be coordinated in terms of corporate law with the articles of association of the target company, as they can affect the company’s capital and shareholder structure. Furthermore, the requirements of the GmbHG (e.g., the prohibition of issuing shares below par value, § 9 GmbHG), the AktG, and, where applicable, the KWG must be considered. The registration of the new shares in the commercial register may require notarization if, for example, a capital measure is involved.
What co-determination rights do holders of convertibles have under the law?
Holders of convertibles do not have classical shareholder or stockholder rights as long as the conversion right has not been exercised. They are generally creditors of the company with contractually regulated claims. Co-determination rights, for example concerning company resolutions, do not usually exist unless expressly granted in the convertible contract. Only upon exercising the conversion right and the corresponding capital measure (entry in the shareholder list or registration in the share register) do rights such as co-determination or voting rights arise. However, there are often certain information rights or veto rights for essential decisions (so-called “investor protection clauses”), which can be arranged individually by contract.
What regulatory requirements must be observed when offering convertibles?
The public offer of convertibles may trigger regulatory obligations, particularly under the Securities Prospectus Act (WpPG) and the EU Prospectus Regulation. If convertibles are issued to a broad group of investors, it must be checked whether a prospectus obligation exists. However, offers to fewer than 150 investors or with a total value of less than 8 million euros within twelve months (§ 3 WpPG) are often exempt. If convertibles are issued in the form of securities, they frequently fall within the scope of the MAR (Market Abuse Regulation) and may be subject to reporting obligations. In individual cases, a permit requirement under the German Banking Act (KWG) may also exist, especially if the structure resembles banking activities or if crowd-investing models are involved.
Is the issuance of convertibles to be treated as a capital measure under company law?
The issuance of a convertible itself does not yet constitute a capital measure in the civil or corporate law sense, but rather initially gives rise to a claim from a convertible loan or a similar contractual claim. Only with the exercise of the conversion right, which regularly goes hand in hand with an increase in share capital (for a GmbH) or registered share capital (for an AG) and leads to the granting of new shares/stocks, does it become a real capital measure. Such measures require separate shareholder resolutions, notarization, and registration in the commercial register. The exact execution and who is authorized to participate (e.g., existing shareholders vs. new investors) should be clearly defined in the convertible contract in advance.
What tax implications must be considered with convertibles?
Legally, convertibles are relevant for tax purposes both at the company and investor level. During their term, the convertible is treated as debt capital, and interest paid is deductible as business expense for the company and taxable as investment income for the investor. The conversion into equity can be a tax-neutral capital measure if properly executed. Upon later disposal of the acquired shares/stocks, capital gain holding periods and withholding tax rates may apply. In the international context, double taxation agreements and withholding tax issues must be taken into account, especially with foreign investors.
What specific risks and legal conflict potentials do convertibles entail?
Convertibles entail various legal risks. The potential for disputes exists particularly regarding the interpretation of conversion conditions, such as the valuation of the company at the time of conversion (“Valuation Cap”, “Discount”), interest calculation, and the modalities of the capital measure. Unclear provisions on the cooperation obligations of shareholders, for example during a capital increase, can also lead to conflicts. Another risk lies in the possibility that, after conversion, existing shareholders perceive dilution of their rights or shares and may respond with challenges to resolutions. Finally, pre-emptive rights stipulated in the articles of association or approval requirements may not have been properly observed, leading to potential claw-back claims. To minimize such risks, a detailed, legally sound contract structure is essential.
What registry steps are required after exercising the conversion right?
After exercising a convertible’s conversion right, registry steps must be prepared. For a GmbH, after the resolution on a capital increase, the change in the shareholder list must be submitted and notarized by a notary. The new shareholder is then officially registered. For an AG, the implementation of the capital increase and the corresponding amendment to the articles of association must be registered with the commercial register, and the new shares must be entered. Only after full completion and registry entry does the new shareholder obtain the rights of a shareholder or stockholder. Inadequate or incorrect register notifications may jeopardize the effectiveness of the share transfer. Statutory deadlines and form requirements — such as notarization — must be strictly complied with.
