After extensive research and preparation, on September 1, 2023, the convertible loan instrument, long-awaited in the Hungarian startup and innovator ecosystem, will be introduced. The annual startup reports (based on a sample size of n=160) consistently highlight the most desired modification proposal: reducing the administrative and legal burdens of capital raising. This financing option significantly meets this expectation.
Convertible loans, more commonly known as convertible notes in the financial sector, are primarily used and preferred by angel investors in the pre-seed and seed stages.
This method allows investors to extend a loan to the venture under certain conditions or events, upon which it converts into equity. These events typically include subsequent rounds of funding, conversion events, or exits. Until these events occur, the convertible loan behaves like a debt instrument. The terms of financing, such as maturity, interest rate, and discount rate for equity determination, are defined during the loan provision.
Convertible loan agreements often specify a valuation cap, which is the maximum company valuation at which the loan amount converts into equity, or a discount rate used to discount the established company valuation before equity issuance.
Advantages include no need for company valuation, rapid and flexible financing. Speed, flexibility, and simplicity are particularly crucial for both the startup and innovator ecosystem and for angel and venture capital investors. Compared to traditional investment structures, bureaucratic burdens are mitigated, and the need for legal and tax advisory services can be avoided.
A disadvantage for business founders is the potential unwanted dilution in ownership structure.
Providing convertible loans does not qualify as lending money, thus it is not subject to authorization. However, there are certain limits to these transactions:
- In a year, a natural person lender can engage in a maximum of 15 convertible loan transactions.
- For natural persons, the convertible loan portfolio cannot exceed 500 million HUF, while for legal entities, it cannot exceed 2 billion HUF.
- Convertible loans can only be accepted by enterprises that are not older than 5 years and have not paid dividends.
Surveys conducted in the corporate, especially startup ecosystem have consistently shown the market's long-standing demand for enabling convertible loan transactions. So far, this path has only been viable through complex legal loopholes and involvement of foreign owners.
A creation of legal regulations for convertible loans, stakeholders involved in advocacy aim to establish terms for Simple Agreement for Future Equity (SAFE) agreements. The goal is to legally formulate investment terms on a single A4 page with a SAFE agreement.
A noticeable trend is that venture capital investors are increasingly shifting focus from mature companies to early-stage startups and innovative ventures in the pre-seed and seed growth phases. As a result, reducing administrative and legal burdens for investment opportunities can significantly contribute to Hungary's innovation capability.
Written by Kristóf Kukorelli
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