A stimulating investment scheme for Hungarian startups and start-up innovator ecosystem

Following extensive research and preparatory work, the loan-to-capital instrument will be introduced on 1 September 2023, a long-awaited tool for the Hungarian startup and innovator ecosystem. Reducing the administrative and legal burdens of raising capital is the most frequently requested change proposal in the annual startup reports (n=160 sample size). This could be significantly addressed by this financing option.

The convertible loan (more commonly known as a convertible note in the financial sector) is the preferred investment method used by angel investors, mostly in the pre-seed or seed stage.

This method allows the investor to grant a loan to the company as part of his investment, which becomes a share in the business when certain conditions and/or events occur. These events may be additional capital-raising rounds, conversion events, or exits. Up to these events, the convertible loan behaves like a regular loan. The terms of the financing are determined at the time the loan is granted. Typically, the term, interest rate, or discount rate is used to determine the business portion.

Typically, equity convertible loan contracts specify either the valuation cap at which the amount of the equity convertible loan becomes a business interest or the discount rate at which the stated goodwill must be discounted before the business interest is determined.

The advantage is that it does not require a company valuation and is a fast and flexible financing tool. And speed, flexibility, and simplicity are particularly important for the startup and innovator ecosystem as well as for angel and venture capital investors. Compared to traditional investment vehicles, the bureaucratic burden is reduced and the need for legal and tax advice is avoided.

A disadvantage for business founders is that there may be an unwanted dilution in the ownership structure. The provision of a loan that can be converted into capital is not considered to be a money lending activity and is therefore not subject to authorisation. However, there are certain limits to these transactions:

• a natural person may enter up to 15 equity loan transactions per year,
• in the case of a natural person, the total amount of loans convertible into equity may not exceed HUF 500 million, while the total amount of loans convertible into equity of a legal person may not exceed HUF 2 billion,
• finally, convertible loans into equity can be taken out by companies that are not older than 5 years and have not yet paid dividends.

According to the unanimous results of surveys conducted in the corporate ecosystem, particularly in the start-up ecosystem, the market has long been calling for the possibility of loan transactions that can be converted into equity. Until now, this has only been possible by circumventing complex legal loopholes and involving a foreign owner.

In addition to developing the legal framework for loan-to-equity, the advocacy group also set out to develop the terms of the SAFE (Simple Agreement for Future Equity) agreements. The SAFE agreement is effectively a legal form of investment on an A/4 sheet of paper.

There is a trend for venture capital investors to shift their focus from mature companies to newly formed pre-seed and seed growth start-ups and innovative companies. As a result, the reduction of administrative and legal burdens on investment opportunities can make a significant contribution to Hungary’s capacity for innovation.

Written by Kristóf Kukorelli

Source: Nagy segítséget kapnak a hazai vállalkozások – Gyorsul és egyszerűbbé válik a tőkebevonás – Portfolio.hu

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