The convertible loan: startup’s friend or foe? - An inquiry into the need for regulation of the convertible loan in Dutch tech startups

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The convertible loan:

startup’s friend or foe?

AN INQUIRY INTO THE NEED FOR REGULATION OF

THE CONVERTIBLE LOAN IN DUTCH TECH STARTUPS

ANNE-CLARINE PROSMAN ANNE-CLARINE PROSMAN 10755748

ANNE-CLARINE_PR@LIVE.NL LL.M. LAW & FINANCE

SUPERVISOR: R.J. DE WEIJS SECOND READER: X. WANG 12-07-2020

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Abstract

Through literature research this thesis analyzes the use of convertible loans in tech startup financing and pinpoints any problems that can arise from using this instrument. It examines the question whether and how the Dutch legislator should interfere with the use of

convertible loans in startup financing. Market solutions are analyzed, and the convertible loan is compared to its alternative’s debt and equity financing. The legal rationale of and possible for regulation is discussed, as well as regulatory solutions.

To manage agency costs between the founder and the investor, the founder as the weaker party should be protected by an obligation to notify and to do proper due diligence, which should include getting assistance from an impartial legal counsel.

To manage the agency costs in regard to the creditor, there is no need to automatically subordinate the convertible loan.

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Introduction

In this thesis the convertible notes, or convertible loan, used as a financing instrument in tech startup is discussed. The convertible loan is a type of hybrid financing1_{, because it is debt} until it converts into equity.

1_{Seth C. Oranburg, 'Start-Up Financing', Start-Up Creation (2nd edn, Woodhead Publishing 2020)}

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Startups typically use funding rounds to finance their operation. These rounds are marked Series A, B, C etc. In these rounds the investor invests in equity. However, this type of funding is not always available or is not always an optimal fit.

Convertible debt was traditionally used as bridge financing, to carry over to the next funding round. This was done either to help the startup to achieve a new milestone so the value would go up in the next funding round, or to keep a struggling startup running until a buyer could be found. These loans would accrue interest, which would become payable at maturity if the loan was not converted. Because a simple interest was not enough to compensate the noteholder for the risk of default, noteholders would receive a warrant coverage, providing them with warrants that could be used to acquire shares at a designated price.

Bridge loans were not so much debt but rather deferred equity investments, because the noteholders expectation was not to get repaid but to receive equity at a future date. Instead of using equity, which could incorporate many of the same features, convertible debt was used for 1. its simplicity and 2. its priority in liquidation.2

Around 2005 the overhead and marketing cost of beginning a new tech startup started to fall. This was in large part due to the invention of cloud computing and open-source software. There was no longer a need for expensive servers and all kind of tasks (editing, emailing etc.) could be done on a computer for free. These developments and the birth of social media also made it possible for a startup to reach a market with minimal costs and efforts.3

This affected the investment needs of startup founders, allowing them more time to grow the business before having to turn to equity investments. Seed4_{investing became a point of} focus, because this allowed the founder to reach a high(er) valuation and better negotiating position before turning to equity investment, which meant that any equity investor would take a smaller stake in the business compared to if they invested at an earlier stage.

2_{John F. Coyle and Joseph M. Green, 'Contractual Innovation In Venture Capital' (2014)}

<http://www.hastingslawjournal.org/wp-content/uploads/Coyle-66.1.pdf> accessed 3 June 2020, paragraph II.C.

3_{John F. Coyle and Joseph M. Green, 'Contractual Innovation In Venture Capital' (2014), paragraph III.A.} 4_{This term can be confusing as it can be used to refer to different lengths of the startups early life. In this}

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Raising a larger seed round meant that early investors, typically business angels (BAs) would be putting in more money, for which they wanted to be sufficiently compensated. Selling them (convertible) preferred stock, like the kind that would be issued to investors in the funding rounds, would be complicated and come with high legal fees, a situation neither party was interested in. This opened the way for the convertible note to become the instrument of choice in seed financing.5

Although regarded simple, the convertible loan deal comes with its own challenges. The two agency problems that arise from using the convertible loan are those between the investor and the founder and between the founders and investors versus the creditors. In both relationships the investor and founders have incentive to act opportunistically, as they have an information advantage over each other and the creditors.6

The importance of SMEs for a country’s economy are undisputed. SMEs are drivers for innovation and provide job opportunities.7_{It thus makes economic sense to stimulate this} industry. For startups in need of financing, the type of investor can be a big influence on their success. Investors, on the one hand, can offer their services and network8_{, but on the other} hand, can also take over control and solely act in their own (monetary) interests. Startups should thus be able to work freely with investors of their choice, but be shielded from expropriation. If needed, the law, either in the form of rules or standards, can curb opportunism by introducing default or mandatory rules.9

The research question answered in this thesis is: Should the Dutch legislator regulate the use of convertible notes in tech startup financing, and if yes, how? To answer this question, a number of sub questions are discussed first. 1. What are convertible notes, what are their features and how do they work? 2. What are the benefits of using convertible notes in startup

5_{John F. Coyle and Joseph M. Green, 'Contractual Innovation In Venture Capital' (2014), paragraph III.B.} 6_{John Armour, Henry Hansmann and Reinier Kraakman, 'Agency Problems And Legal Strategies', The}

Anatomy of Corporate Law (3rd edn, Oxford University Press 2017)

<https://www.oxfordscholarship.com/view/10.1093/acprof:oso/9780198739630.001.0001/acprof-9780198739630>, paragraph 2.1.

7_{See for example: Stephen Chong and others, The Role Of Small And Medium-Sized Enterprises In The}

Dutch Economy; An Analysis Using An Extended Supply And Use Table (2012) <https://www.cbs.nl/nl-nl/achtergrond/2018/34/de-rol-van-het-mkb-in-de-nederlandse-economie-2012> accessed 7 June 2020.

8_{Stephanie A. Macht and John Robinson, 'Do Business Angels Benefit Their Investee Companies?'}

(2009).

9_{John Armour, Henry Hansmann and Reinier Kraakman, 'Agency Problems And Legal Strategies', The}

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financing and to whom? 3. What are the problems that arise from using convertible notes in startup financing and who is bearing the cost of the risk? 4. How are these problems dealt with by the market? 5. To what extend is it necessary for Dutch legislators to regulate the use of convertible notes in startup financing? 6. If regulation is appropriate, how should this be done?

This thesis will be organized as follows. In the first chapter the convertible note and its features are discussed. Chapter 2 will cover the issues relating to both agency problems that arise in convertible debt financing. Chapter 3 will analyze private solutions to these

problems. Chapter 4 will consider what type of regulation, if any, is suitable for either of the agency problems.

This thesis does not take into account fiscal matters, not does it discuss securities regulation. These could be of impact on why parties opt for a convertible loan but should not change the results of this research.

To better understand how the convertible loan is used in practice, I spoke to several people in the industry. I would like to thank Evelien de Vries (legal counsel at TechLeap), Jessica den Dekker (lawyer at Houthoff, working in transactions), Joep van Gelder (startup coach), Lotte Geldermans (product owner at Pitchdrive, a startup aimed at connecting BAs and founders) Jeroen Rotteveel (CEO and founder of ISIS Space) and Matthias Smets (legal counsel at Pitchdrive).

I would also like to express my gratitude to my supervisor Rolef de Weijs for his guidance and encouragement, and Xinyi Wang for her advice and kind assistance. I greatly appreciate it.

Chapter 1 The convertible loan

Tech startups are high-risk, high-growth business ventures. Founders often finance a large part of the operations by putting in their own money, or that of their friends and family.10_For

10_{Netherlands Enterprise Agency, 'Nederlands Investeringsklimaat Voor Technostarters (9-Meting)'}

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many young startups the only possibilities for receiving financing are either through equity investments or through convertibles loans, because the options for getting traditional (bank) loans are limited.11_{Equity investments are simply put a capital buy-in, but require the startup} and its investor to agree on a valuation of the shares, which is not straightforward for a startup with no assets but just a lot of potential.

Therefore, convertibles loans are often used for financing in the early stage, so-called seed financing.12_{Not only does this enable the startup to put off a detailed valuation, they are also} cheap, quick and easy as there is no need for a notary nor for a transaction document.13

Convertible loans can also be used as bridge financing. This is extra financing a startup needs between two funding rounds, either because money is tight or to invest so that the valuation at the next round will be much higher.

1.1 Key actors

The investors that use this instrument are professional investors, mainly Business Angels (BAs) and Venture Capitalists (VCs). BAs are ‘generally high net-worth individuals who typically invest in small, private firms on his or her own account’.14_{Angel investors can be} organized in Angel Portals, also called BA Networks, which facilitate the angel investing process.15_{In the Netherlands BAs were involved in 2,8% of tech startup investments in}

11_{Seth C. Oranburg, 'Start-Up Financing', Start-Up Creation (2nd edn, Woodhead Publishing 2020),}

paragraph 4.2.3.

12_{Exact numbers are unknown, but many experts working inside the industry notice the increased use of}

convertible note financing. See f.e. Ytsen van der Meer, 'Welke Vorm Van Kapitaal Is Het Meest Geschikt Voor Jou?' (Investerings- en Ontwikkelingsmaatschappij voor Noord-Nederland, 2019)

<https://www.nom.nl/media/kennisblogs/ytsen-van-der-meer-welk-vorm-van-kapitaal-is-het-meest-geschikt-voor-jou/> accessed 23 April 2020.. In America around 50% of angel and early stage deals are estimated to be convertible loans, see Leena Rao, 'Convertible Equity, A Better Alternative To Convertible Debt?' (Techcrunch, 2012) <https://techcrunch.com/2012/08/31/thefunded-founder-institute-and-wilson-sonsini-debut-startup-friendly-seed-financing-vehicle-convertible-equity/> accessed 17 April 2020.

13_{Maurits Bos, 'The Capital Waters Convertible Loan Agreements Are Now Online' (Capitalwaters.nl,}

2015) <https://www.capitalwaters.nl/blog/capital-waters-convertible-loan-online/> accessed 7 July 2020.

14_{Andrew Wong, Mihir Bhatia and Zachary Freeman, 'Angel Finance: The Other Venture Capital' (2009)}

18 Strategic Change <https://doi.org/10.1002/jsc.849> accessed 3 June 2020.

15_{John May, 'Structured Angel Groups In The USA: The Dinner Club Experience' (2002) 4 Venture}

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2015.16_{BAs are deserving of their name: they help overcome funding gaps, offer their own} expertise and involvement, offer their network and leverage further funding.17

Venture capitalists are firms that ‘devote significant management resources to understanding new technologies and markets, finding promising startups in those spaces, providing them with financial resources, and coaching them through the early parts of their life.’18_{In the} Netherlands regional VCs were involved in 40% of tech startup investments in 2015.19_Of VCs investments in the Netherlands in 2018 only 6% went to startups in the seed stage, as VCs prefer to invest in equity funding rounds.20_{VCs have a reputation of being tougher and} more professional than BAs.21

1.2 Key features of the convertible loan

A convertible loan, in the form of promissory notes, are a type of hybrid financing. Typically, the notes will have a maturity date or a trigger at which time the noteholder has the right to convert the loan into an equity stake in the company. Before the conversion the convertible loan behaves like a regular loan, the noteholder does not have any shareholder rights. Unlike a regular loan the convertible loan does not require immediate payment of interest. If the noteholder does not want to convert, she will have a claim on the loan plus the accrued interest.

If the noteholder choses to convert, she will receive (preferred) stock of the value of the loans plus accrued interest. Conversion typically happens with a conversion discount in

16_{Netherlands Enterprise Agency, 'Nederlands Investeringsklimaat Voor Technostarters (9-Meting)', graph}

24.

17_{Stephanie A. Macht and John Robinson, 'Do Business Angels Benefit Their Investee Companies?'}

(2009) 15 International Journal of Entrepreneurial Behavior & Research <https://doi.org/10.1108/13552550910944575> accessed 1 June 2020.

18_{Antonio Davila, George Foster and Mahendra Gupta, 'Venture Capital Financing And The Growth Of}

Startup Firms' (2003) 18 Journal of Business Venturing <https://doi.org/10.1016/s0883-9026(02)00127-1> accessed 31 May 2020, introduction.

19_{Netherlands Enterprise Agency, 'Nederlands Investeringsklimaat Voor Technostarters (9-Meting)', graph}

36.

20_{Deloitte and StartupDelta (now TechLeap), 'The Next Chapter For Corporate Venture Capital In The}

Netherlands' (2019) <https://www2.deloitte.com/content/dam/Deloitte/nl/Documents/mergers-acquisitions/deloitte-nl-fa-the-next-chapter-for-cvc.pdf> accessed 7 July 2020, graph page 18.

21_{See for example this Dutch article comparing the two: Sjoerd Mol, 'Into Venture Capital: Zo Kies Je}

Tussen Een Business Angel En Een Venture Capital-Fonds' (Sprout, 2018)

<https://www.sprout.nl/artikel/financiering/venture-capital-zo-kies-je-tussen-een-business-angel-en-een-venture-capital> accessed 24 April 2020.

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valuation compared to new investors. This mean that the convertible loan, principal plus interest, converts into shares at a discount relative to value ascribed to the shares issued at the maturity date.

Let’s say that a startup agrees to a convertible deal for €860.000 with an 8% interest rate, compounded annually. After two years the loan will be worth €1 million, at which point the loan converts. Now the deal includes a 20% discount. Assume that at the following funding round an investor pays €10 per share. At this price, the noteholder should receive 100.000 shares. Due to the discount, however, the noteholder only needs to pay €8 per share, giving her 125.000 shares.

Additionally, the investor can set a conversion cap, which dictates the highest value the startup can be priced at for determining the number of shares the notes will convert into. The following example demonstrates how the conversion cap works. A startup again agrees to a convertible deal for an amount of €860000 that will be worth €1 million after 2 years with 8% annually compounding interest. The deal includes a cap for €5 million. After the two years the loan will convert into equity. Assume that at conversion the firm is valued at €7,5 million, this would give the noteholder 1/7.5th _{or roughly 13% of the shares. However, due to} the cap, the firms value should be treated as if it were €5 million, giving the noteholder 1/5th or 20% of the shares.

A real-life example of this is Peter Thiel’s investment in Facebook. Thiel invested $500.000 in Facebook in 2004, likely at a 2% interest rate. In 2005 Facebook raised $12.7 million in their first round of equity funding (called Series A financing) and was valued at $100 million.22_{At this point Thiel’s loan, which with interest grew to about $510.000, converted} and he received gave him a 10,2% equity stake. A quick calculation shows that $510.000 out of $100 million should give him about a 0,5% stake, far less than the 10,2% he received. This mean that the cap they agreed on was $5 million (0,51/5 = 10,2%). Thiel’s investment grew from $500.000 to value of $10,2 million (10,2% of $100 million) in a year.

22_{'Tracking Facebook's Valuation' (The New York Times, 2012)}

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The conversion cap only puts an upside limit to the startups valuation, ensuring that the investor receives “at worst” a set percentage of the shares. There is no downside limit, meaning that if the startup is worth far less at conversion than expected, the investor receives more shares than parties had anticipated.

These measures ensure that the seed investor participates in any upside as a compensation for the risk they took by investing early. If parties agreed to both a conversion discount and conversion cap, the noteholder can choose which method they will use at conversion.

At what point in time the convertible loan converts, depends on what parties have agreed on. Typically, a conversion trigger and a maturity date are used. The conversion is triggered at, for example, the next funding round. Typically, this maturity is set at 1 to 2 years.23_{The idea} behind using a convertible loan is that the startup is not likely to be able to pay the loan back at maturity. Some convertible loans therefore do not even have a maturity date at all,

depending only on a conversion trigger.24

In bankruptcy, convertible loans are treated like any other unsecured loan. Parties can agree to subordinate the convertible loan, but the loan is not automatically subordinated by Dutch law. In the Netherlands the trend is to subordinate the convertible loan. In the SEED Capital Scheme, that provides capital to investment funds that invest risky capital, all convertible loans are subordinated.25

1.3 protecting the investor

As has become clear, these measures serve to protect and compensate the early investors. This is also done by putting anti-dilution clauses in the convertible loan agreement. These provisions are designed to protect the investor against dilution, which occurs when

additional shares are issued in a new funding round. Dilution can happen in two forms:

23_{'Wat Zijn Financieringsalternatieven?' (Firm24)}

<https://www.firm24.com/kennisbank/converteerbare-obligatie-startup/> accessed 31 May 2020. Legdy reports that the maturity date is usually set after 18-24 months.

24_{Ledgy reports that over 60% of the loans they registered do not have a recorded maturity. This does not}

necessarily mean that no date is agreed upon, but it does show that is does not really matter because the startup does not expect is has to pay back the loan.

25_{Regeling van de Staatssecretaris van Economische Zaken en Klimaat van 7 juli 2019, nr. WJZ/}

19140701, tot wijziging van de Regeling nationale EZ-subsidies in verband met een tender van de Seed capital subsidiemodule specifiek voor klimaat en energie 2019, “converteerbare lening: geldlening, steeds resulterend in een achtergestelde vordering”

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percentage dilution or economic dilution. In the case of percentage dilution, the investor’s percentage of ownership decreases, in economic dilution the investors economic value of the ownership decreases.26

In startup financing two types of clauses are used: the full-ratchet and the weighted average ratchet.27_{A full-ratchet clause protects the seed investor from any economic dilution of their} investment in subsequent rounds of funding.28_{If the investor holds 1 million preferred stock} for the price €1, but in a second investor buys new common stock for €0,50, then the investor can convert her preferred stock into 2 million shares of common stock. This is essentially giving the seed investors new shares at no additional cost, even if there was only a small number of shares issued at a lower price. The founders do not receive extra shares, so as a result they get diluted.

If the startup is doing well and has no problem finding investors, the full-rachet is not very problematic. However, if the startup is forced to issue additional common stock at a lower price than the investor paid, the full-ratchet kicks in. Lower here refers to lower than the price the seed investor paid, not the market price of the shares. If the new investor pays the market price29_{, the seed investor is not harmed, but can still exercise the full-ratchet.}

Alternatively, the milder weighted average approach can be used. This method takes into account how many new shares are issued to determine how the preferred stock can be

converted into common stock. The conversion price is between the original share price, in the previous example €1, and the price per share in the dilutive issuance, in our example €0,50. The adjustment is larger if more stock is issued at a lower price. The preferred stock can then for example be converted into common stock as if the price of that were €0,75. This would turn 1 million shares of preferred stock into 1,5 million shares of common stock.30

26_{Micheal A. Woronoff and Jonathan A. Rosen, 'Understanding Anti-Dilution Provisions In Convertible}

Securities' (2005) 74 Fordham Law Review <https://ir.lawnet.fordham.edu/flr> accessed 1 June 2020, paragraph 1-2.

27_{'Antidilution Explained: Full-Ratchet And Weighted-Average Provisions' (VCExperts)}

<https://blog.vcexperts.com/2016/11/16/antidilution-explained-full-ratchet-and-weighted-average/> accessed 1 June 2020.

Securities' (2005), paragraph 3.B.1.a.

29_{Although for early-stage startups it is hard to say what would be the market value of the startup.} 30_{Micheal A. Woronoff and Jonathan A. Rosen, 'Understanding Anti-Dilution Provisions In Convertible}

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To further protect the investor, an early exit multiple can be used in case the startup gets sold before the loan has been converted. Early investors are in this case also rewarded for the risk they took by giving them a multiple of their investment back, instead of the original amount plus interest. It is in the best interest of the noteholder to negotiate any acquisition or

liquidation terms in their contract. This is also true for founders, as they can get blindsided by the amount after they have already agreed to the acquisition.31

Chapter 2 Issues in startup financing related to convertibles

There are several issues that can arise when convertibles are used in startup financing. This can be regarding the valuation and conversion, payment upon maturity, anti-dilution clauses, governance, acquisition and bankruptcy.

2.1 Valuation and conversion

One of the main attractions of using convertible loans is that the issue of valuation can be postponed until conversion. This is in the interest of startups because at the time of the investment the company is likely not worth that much, but after the investment it can grow quickly. An investment of a couple thousand euro’s will thus not require the founders to hand over a majority of the shares. To make sure that this first investor, who is taking a lot of risk (also relative to later investors), doesn’t end up with just a very small stake, the conversion cap or discount are used.

This cap or discount is also beneficial for the investors, but not necessarily for the founders and other early investors32_{who put in their money without receiving these benefits. The} investor who benefits from a cap or discount takes a bigger percentage of the ownership at the expense of these original shareholder, or they get perks that original creditors do not receive for their even earlier, thus riskier, investment.

31_{Ed Zimmerman, 'Startup Founders: Avoid These Convertible Note Glitches' (Forbes, 2016)}

<https://www.forbes.com/sites/edwardzimmerman/2016/07/12/startup-founders-avoid-these-convertible-note-glitches/#46ece31d1c4d> accessed 3 June 2020.

32_{In most startups the founders and their friends and family (FFF investors) invest first, these are the}

original investors, see Seth C. Oranburg, 'Start-Up Financing', Start-Up Creation (2nd edn, Woodhead Publishing 2020), paragraph 4.1 and figure 4.1.

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This is not per definition problematic as seed investors do carry a lot of risk. 8 out of 10 startups don’t succeed, so investors need to balance what they lose with what they gain. Seed investors often also offer the startup more than just money; they share their network, act as a coach and sometimes even provide housing.

The cap especially can cause some issues for the founders, because if the cap does not include a downside limit. This mean that if the valuation at conversion turn out to be much lower that the cap, the founders have no choice but to give away a large share of the ownership.

Suppose a seed investor invested $100.000 and negotiated a $1 million cap. This means that the investors will get 10% ownership at conversion. If at conversion the value actually turns out to be $0,5 million, the investor gets a very substantial 20%, because the cap does not have a minimum. The founders might have never intended to give such a large share of the

ownership to one investor and would have been better of negotiating an agreed price in the first place.

Horotan shows mathematically that for a certain expected growth rate, a certain discount rate is required to provide the investor with the same upside as she would have received as an equity investor.33_{A common 20% discount corresponds with about a 25% expected growth} rate, not a large rate for an early tech startup full of potential. If a firm is expected to grow by a 100%, which is not unusual, the discount rate should be 50%, which is far outside the usual discount range.

Simply opting for a higher discount is not always a feasible solution as this will likely sound unreasonable to new investors.34_{These new investors have a hind-sight bias. If the startup is} successful enough to gain new investors, the risk in that particular investment was not that big. This excludes, however, the overall risk that seed investors take on in their undertakings. It is therefore not correct to assume that investors are always adequately compensated

through the conversion discount.

33_{Adrian Horotan, 'Convertible Debt With Discount Sacrifices The Upside For Early-Stage Investors'}

(2012).

34_{'Convertible Notes For Angel Investing' (AngelBlog)}

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It is also worth noting that the assumption that using convertible debt allows for the valuation to be postponed, is not completely correct. The valuation is still done implicitly by the

investors and through the determination of the discount or cap. What is avoided is a detailed valuation and argument thereof, as well as the drawing up of a transaction agreement.35 Making sure that the cap and discount are reasonable is very much an issue that the founders should be concerned about when entering into a convertible loan deal.

2.2 Maturity

Convertible debt either gets converted at maturity or when a triggering event occurs, possibly combined with a maturity date in case this event never occurs. Startups run into problems if the noteholder decides not to convert but instead demands her loans to be paid back. When this is possible depends on the terms agreed upon in the debt contract. In some instances, convertible notes always convert into equity (this is convertible equity), otherwise it is possible upon maturity at the option of the noteholder.

For (early-stage) startups with little to no assets, this is a death sentence. A noteholder will therefore only be used if the noteholder has some interest in terminating the startup, allowing room for foul play.

Investors can pull their money out for legitimate reasons, in situation that startup is performing poorly, perhaps because its founders are irresponsible or because of market conditions. There are, however, also accounts that venture capitalists prematurely push startups into bankruptcy because they can gain more from letting the assets, like valuable pieces of intellectual property (IP), go to auction now and reinvesting their money.36_{This is} especially problematic if the VC has many ties in the industry and might therefore benefit from the IP ending up in a competitors hand.

35_{Adrian Horotan, 'Convertible Debt With Discount Sacrifices The Upside For Early-Stage Investors'}

(2012) 15 The Journal of Private Equity <https://doi.org/10.3905/jpe.2012.15.2.025> accessed 2 June 2020.

36_{Daniel Fisher, 'The Latest Craze In Silicon Valley: Bankruptcy' (Forbes, 2017)}

<https://www.forbes.com/sites/danielfisher/2017/03/15/the-latest-craze-in-silicon-valley-bankruptcy/#33183d491664> accessed 2 June 2020. I have not been able to find any specific cases where convertible notes where misused, but I have heard from the people I interviewed that this is possible in rare cases.

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Investors who abuse their powers in such a way face reputation damage. Rumors get around in the startup scene. Recourse hubs for investors, like The Funded, have a public list of banned VCs.37_{Founders should be careful who they interact with and understand there is} always a risk that they will be duped.

2.3 Anti-dilution clauses

The full-ratchet anti-dilution clause gives the investor the right to convert her preferred stock into common stock at the price the new common shares are sold for. Using this clause has some negative consequences for the founders. Through the conversion into common stock the founders and the new shareholders lose value, because the total value is now divided over more shares, making individual shares of the new investor worth less. Potential investors who anticipate this might no longer be inclined to invest. The seed investor also has less incentive to participate in additional funding round, because the value of her seed value grew so large, that any stake she can acquire through a new investment pales in comparison.38

Full-ratchet clauses are seen as unfair39_{, and are even coined as the “antidilution death} spiral”40_{. Venture capitalist who insist on using the full-ratchet are nicknamed “vulture} capitalists”.41_{It is not surprising that full-ratchet clauses are hardly ever used in startup} financing nowadays.42

Woronoff and Rosen see the point of the anti-dilution clauses as protection against inaccurate valuation arising from information barriers or bad management. At the time of the seed investment, the value of the startup is not yet clear (and often not even established). It is possible that the deal the investor made, was based on a valuation that turns out to be too high or has declined due to issues in the startup’s performance. This then becomes clear during the funding round. The costs of this is shifted to the common stakeholders (fully in the case of

37_{See: http://thefunded.com/funds/banned.}

38_{'Full Ratchet - Overview, How It Works And Practical Example' (Corporate Finance Institute)}

<https://corporatefinanceinstitute.com/resources/knowledge/strategy/full-ratchet/> accessed 1 June 2020.

Securities' (2005), paragraph 3.B.1.a.

40_{Timothy J. Harris, 'The Antidilution Death Spiral' (2002) 5 The Journal of Private Equity}

<https://doi.org/10.3905/jpe.2002.320006> accessed 2 June 2020.

41_{'Antidilution Explained: Full-Ratchet And Weighted-Average Provisions' (VCExperts).}

42_{Mark Suster, 'Why Convertible Notes Are Sometimes Terrible For Startups' (Techcrunch, 2012)}

<https://techcrunch.com/2012/09/05/why-convertible-notes-are-sometimes-terrible-for-startups/> accessed 10 April 2020: “You rarely find full ratchets in early-stage deals anymore.”

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the full-ratchet, or partly in the case of the weighted average ratchet). It makes sense for investors to want this when investing in startups, as this provides protection against the uncertainties in the valuation at the moment they make the seed investment. For founder this can feel unfair regardless, because the valuation drop can also be caused by other factors, which this clause does not account for.43

2.4 Agency problems

2.4.1 Between founders and investors

There is a power dynamic between founders and investors. Investors are typically

professionals who have plenty of experience, whereas founders are usually less experienced and eager to get financing. This might incline them to agree with terms without fully

understanding the consequences. Founders on the other hand have an information advantage over the investor as to the actual business.44

Until the loan converts into the equity, the noteholder is not entitled to shareholder rights such as voting. Since convertible note contracts seldom include covenants, the founders are generally free from investor influence until conversion.45_{Only at conversion does it become} clear how much of the startup’s ownership falls into the investor’s hands. Unless previously agreed, it is not clear how much power this gives the investor. Founders should remember that they are entering into a long-term relationship and should consider how the investor will act as a shareholder.46

But even before the loan converts, a conflict of interest can arise between de founders and the investor. If a conversion discount, the noteholder will benefit if the loan converts when the stock value is low, so it can get a higher number of shares, while the company is better off waiting for a higher valuation. If a cap is used, both the founders and the investor benefit

Securities' (2005), paragraph 3.B.1.

44_{Brad Bernthal, 'The Evolution Of Entrepreneurial Finance: A New Typology' (2018)}

<https://www.colorado.edu/law/sites/default/files/attached-files/bernthal_the_evolution_of_entrepreneurial_finance_a_new_typology_2018_byu_l._rev._773_2019.p df> accessed 1 June 2020, paragraph II.A.

paragraph 4.4.2. Note that the Dutch Capital Waters standard convertible loan agreement (discussed in Chapter 3) does include debt covenants, so this might not be as seldom in the Netherlands.

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from a high valuation. However, if the startups value far exceeds the cap, the investor will get a larger percentage of the ownership for their investment than the new investor would,

putting in the same amount of money. This discount can be discouraging to new investors and thus be bad for the founders.47

2.4.2 Between noteholders

Sometimes there are multiple noteholders. Conflict between noteholders can arise if their consent is needed to make a decision. This can be regarding the waiver of provisions in the convertible debt contract. This can for example happen when a startup has raised insufficient financing to trigger the conversion after a funding round. Conflict arises if only some of the noteholders are willing to waive the provision.

2.4.3 Between shareholders

Investors, or at least VCs, often negotiate that they receive preferred stock at conversion. The preferred stock can have varying terms and rights. This structure creates various divergences in interests amongst the shareholders owning different types of stock.48_{Due to information} asymmetry between the founders and the investor, investors have incentive to increase their control. VC’s tend to negotiate preferred stock with voting rights, liquidation preferences and other protective terms, like board seats.49

This can give rise to horizontal agency problems between the investors and the founder and any new or potential investors, who do not like to see one investor to hold so much power.50 Bernthal distinguishes between two types of horizontal conflict. Anticipatory conflict holds new investors back from investing. This could be due to concerns over dilution after the conversion of the loan51_{, or a difference in vision with the seed investor. Post-investment} conflicts are conflicts that arise after the investment is made.52

paragraph 4.4.3.

48_{Elizabeth Pollman, 'Startup Governance' (2019) SSRN Electronic Journal}

<https://doi.org/10.2139/ssrn.3352203> accessed 2 June 2020, introduction.

49_{Elizabeth Pollman, 'Startup Governance' (2019), paragraph I.B.2.} 50_{Elizabeth Pollman, 'Startup Governance' (2019), paragraph II.A.2.}

51_{This does not happen directly to the new investor but to the founders and other common stockholders.}

To replenish their ownership stake, they could decide to issue new stock, which would dilute the new investor.

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Fried and Ganor describe the agency costs that can arise when VC’s owning preferred stock directly or indirectly control the board. VC’s may engage in value destroying behavior by making excessively conservative business decisions. This could make it more difficult and expensive for founders to find seed (angel) investors, because they anticipate this

opportunistic behavior by the VC ex ante. It also negatively effects equity-based employee compensation, which loses its value and incentive effects.53

These conflicts fall under the domain of equity investments more so than in the domain of convertible loans and will not be discussed further. For founders it is important to be aware of the possible conflicts that can arise from giving investors preferred stock.

2.5. Bankruptcy

The question of what happens with convertible debt in bankruptcy is a relevant one, given the fact that most startups fail.54_{Convertible debt used to have security rights, but as the use of} convertibles notes have become more mainstream, these have been written out of the contracts because they only complicated matters, and because most startups don’t have any meaningful assets to serve as collateral.55

Currently, convertible debt is usually subordinated, but noteholders still have priority over shareholders in the event of liquidation.56

Subordination can be contractually agreed upon in Dutch law.57_{This means that in}

bankruptcy, the convertible noteholder will receive payout after the other creditors but before the shareholders.

Even though convertible notes are technically debt and they have debt-like features, such as interest rates and maturity dates, they should also be thought of as deferred equity. The

53_{Jesse M. Fried and Mira Ganor, 'Agency Costs Of Venture Capitalist Control In Startups' (2005)}

<https://papers.ssrn.com/sol3/papers.cfm?abstract_id=784610> accessed 5 June 2020, paragraph III.

54_{1 in 10 Dutch startups reportedly fail: 'ING Alert: Eén Op De 10.000 Starters Wordt Succesvolle Startup'}

(ING, 2015)

<https://www.ing.nl/nieuws/nieuws_en_persberichten/2015/06/ing_alert_een_op_de_10000_starters_word t_succesvolle_startup.html> accessed 4 June 2020.

55_{John F. Coyle and Joseph M. Green, 'Contractual Innovation In Venture Capital' (2014), paragraph}

IV.A.

56_{Brad Bernthal, 'The Evolution Of Entrepreneurial Finance: A New Typology' (2018), paragraph II.A.5.} 57_{Article 3:277(2) of the Dutch Civil Code.}

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noteholder does not intend to have the principle repaid but instead expects to receive equity at conversion. Convertible loans are also unlike traditional debt because they do not contain normal debt covenants and do not require periodic payments. 58_{They do, however,} accumulate interest, which is not just symbolic (in the case the loan does not convert).

If convertible loans are deferred equity, the question arises if they should not be treated like equity in liquidation. This is closely related to the discussion about the shareholder loan. Even if the convertible loan is subordinated, the fact that noteholders (who are set to become shareholders) have a higher ranking than the shareholders might be seen as unfair.59_The noteholder would share in the upside, if the startup did well and the loan converts, but does not fully share in the downside.

In startups with more assets and more creditors, the conflict is more complicated and more pressing. If the convertible (bridge) loan is not subordinated, it could be regarded as unfair to the other creditors. In bankruptcy they have to share with the noteholder, even though the noteholder would have shared in the upside, whereas the regular creditors would not have.

Chapter 3 Market solutions and alternatives

As the use of convertible notes increased, so did the initiatives to solve common problems. These solutions were made by startup accelerators, venture capitalists, lawyers and

entrepreneurs. The most significant solutions that have been made available to the public are convertible equity, SAFE and KISS. This chapter discusses these instruments in

chronological order of their creation.

3.1 Convertible equity

Convertible equity, or convertible security, was created in 2012 by lawyer Yoichiro (Yokum) Taku and entrepreneur and investor Adeo Ressi. Convertible equity is like convertible debt,

IV.A.

59_{This sentiment is not widespread. There is hardly any talk of what happens to convertible debt in}

bankruptcy and if it gets mentioned in blogs it is only seen as an advantage to the investor. One of the very few examples I could find: 'Hoe Werkt Een Converteerbare Lening?' (Investeerders Kennisbank, 2019) <https://investeerders-kennisbank.nl/overeenkomsten/converteerbare-lening/werking-converteerbare-lening/> accessed 4 June 2020. None of the people I interviewed seemed to think it was unfair that the investor has higher ranking because this can be seen as a compensation for the risk they took.

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except that it does not include a maturity date and interest rate provision.60_{Ressi states they} created convertible equity because it does not make sense for a founder to weigh your startup down with debt. In his words, convertible debt creates a situation where investors “get a gun every ten to eighteen months” because at conversion the investors can call the debt,

potentially pushing the startup into bankruptcy or pushing them into debilitating negotiations.61

Convertible equity is not formally debt, nor is it a traditional equity instrument. According to Coyle and Green convertible equity ‘is best conceptualized as a novel type of warrant for which the investor pays full value today for an unspecified future security at some later date’.62

The sample convertible security document that has been shared on Ressi website includes provisions on conversion and change of control. After conversion the security holder is entitled to preferred stock. Use of a conversion cap or discount is optional. Holders holding a majority of the aggregate outstanding can consent to making any amendments.63

3.2 SAFE

SAFE stands for Simple Agreement for Future Equity and is an investment instrument alternative for convertible debt. The instrument was introduced by the American startup accelerator Y Combinator in late 2013 and was invented by its partner Carolynn Levy.64_As seed financing became a funding round on its own, SAFEs developed to keep up with these changes.65_{SAFEs were first used by startups in Silicon Valley, but due to Y Combinators} influence, have been increasingly adopted by startups outside that bubble.66

IV.C.1.

61_{J.J. Colao, 'Adeo Ressi Introduces 'Convertible Equity', Convertible Debt Without Debt' (Forbes, 2012)}

<https://www.forbes.com/sites/jjcolao/2012/08/31/adeo-ressi-introduces-convertible-equity-convertible-debt-without-debt/#5814f09339b1> accessed 4 June 2020.

IV.C.1.

63_{Convertible security financing term sheet template. Found on}

https://fi.co/insight/startups-can-t-borrow-their-way-to-success-by-adeo-ressi

IV.C.2.

65_{Carolynn Levy, 'Safe Financing Documents' (YCombinator,2018)}

<https://www.ycombinator.com/documents/> accessed 4 June 2020.

66_{Joseph M. Green and John F. Coyle, 'Crowdfunding And The Not-So-Safe SAFE' (2016) SSRN}

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Green and Coyle define SAFEs as a ‘deferred equity investment’ that ‘is, in essence, a contractual derivative instrument’.67_{SAFEs has a lot of similarities to convertible debt,} except it eliminates the investors right to loan repayment and accumulation of interest. The debt like features are stripped away.68

SAFEs are still “quick and easy” and allow the valuation of the startup to be postponed.69_Y Combinator offers 4 versions, depending on whether the parties want to work with a

conversion cap, a discount, both or neither. SAFEs are thus similar to convertible debt but prevent issues that can arise at maturity and eliminate the risk that investors might not convert but instead call the debt. SAFEs also include clauses that deal with other issues.

After conversion the SAFE holder receives the same preferred stock that later investors take.70_{It also includes provisions that describe what happens to an investors’ claim in event} of liquidation (acquisition) or dissolution.71_{If future investors are issued better securities, the} SAFE investors can convert to those instead.72_{It gives founders and investors (or the}

majority-in-interest of all outstanding safes) the possibility to amend certain provisions.73

Levy intended the SAFE to be ‘layperson-friendly’ and tried to strike a balance between the needs of founders and the needs of investors.74_{Green and Coyle, however, warn that SAFEs} are ‘highly company-favorable securities’ and that investors who are not familiar with startup investing and convertible notes, might discover that SAFEs are not all that simple.75

67_{Joseph M. Green and John F. Coyle, 'Crowdfunding And The Not-So-Safe SAFE' (2016), paragraph II.} 68_{John F. Coyle and Joseph M. Green, 'Contractual Innovation In Venture Capital' (2014), paragraph}

IV.C.2.

69_{Brad Bernthal, 'The Evolution Of Entrepreneurial Finance: A New Typology' (2018), paragraph II.A.6.} 70_{Safe MFN only (found on https://www.ycombinator.com/documents/), clause 1(a) and definition of}

standard preferred stock.

71_{Safe MFN only, clauses 1(b) and 1(c).} 72_{Safe MFN only, clause 3.}

73_{Safe MFN only, clause 6.}

IV.C.2.

75_{Joseph M. Green and John F. Coyle, 'Crowdfunding And The Not-So-Safe SAFE' (2016), paragraph II.}

They particularly warn against possible complications from using SAFEs in crowdfunding, a topic that is outside the scope of this thesis.

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3.3 KISS

KISS stands for Keep It Simple Security and is an investment instrument created in mid-2014 by 500 Startups, a venture capital firm and accelerator from Silicon Valley. The designed the KISS documents ‘to save founders & investors time and money’, ‘are free legal docs you can use to raise money quickly & easily, hopefully without getting screwed’ and ‘are designed to be flexible without being overly customizable, simple while stull including all of the

necessary features, and balanced from both a company and investor standpoint’.76

500 Startups has created two versions of the KISS, one that is debt-like and one that is

equity-like. The debt-like version accrues interest and has a maturity date, and the equity-like version does not.77_{It is up to the founders and investors to pick either one. In the debt-like} version the loan can be called instead of converted. The equity-like version is like the SAFE except that the makers tried to strike a different balance between the founders and investors.78 The KISS is an equity derivate contract like the SAFE.79

The KISS also includes provisions about the treatment of the KISS holder at conversion, acquisition and maturity. At conversion, which can either happen after the next equity round or at or after maturity (at the election of the majority in interest investors), the KISS holder will receive preferred stock and it is up to the parties to agree to a conversion cap or discount.80_{If the company is sold or acquired, the KISS holder will receive so-called}

conversion shares or a payment that is twice the purchase price.81_{Major investors, who invest} more than $50.000 will get information and participation rights.82_{Parts of the KISS can be} amended with the consent of the founders and the majority in interest investors.83

76_{Gregory Raiten, '500 Startups Announces 'KISS' - 500 Startups' (500, 2014) <https://500.co/kiss/>}

accessed 4 June 2020.

77_{The statement at the top of the debt-like KISS document states that the principal and the accrued interest}

shall be due and payable on demand by the majority in interest investors. In the equity-like version this is left out, but there is still a maturity date. This date serves a purpose in conversion.

78_{Gregory Raiten, '500 Startups Announces 'KISS' - 500 Startups' (500, 2014).}

79_{John F. Coyle and Joseph M. Green, 'The SAFE, The KISS, And The Note: A Survey Of Startup Seed}

Financing Contracts' [2018] SSRN Electronic Journal <https://doi.org/> accessed 4 June 2020, paragraph I.B.

80_{KISS: Debt Version, clauses 2.1, 2.3, 1(a), 1(b) and 1(m). 500 Startups believes that investors ‘deserve}

any extra liquidation preference when the KISS converts’ so it is possible to not use the discount or cap, see: Summary Of KISS Documents (500 Startups)

<https://500startups.app.box.com/s/bqhdzjvx8x8fsn8s4zlt> accessed 4 June 2020.

81_{KISS: Debt Version, clauses 2.2, 1(c) and 1(d).} 82_{KISS: Debt Version, clause 5.2.}

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If the KISS notes convert upon or after the maturity, the Series Seed Documents are used to regulate the created preferred stock.84_{Series Seed Documents were first written by the}

Silicon Valley lawyer Ted Wang in 2010.85_{They are used for equity financing, but have been} influential in some convertible debt agreements for the provisions dealing with stockholder rights after conversion.86

3.4 Capital Waters convertible loan agreements

Capital Water is a Dutch initiative that provides open source legal model documents and other resources to investors and entrepreneurs. In April of 2015 Capital Waters announced standard documents for convertible loan agreements.87_{These documents are used for the} loans given under the corona temporary emergency bridging measure (COL, in Dutch Corona-Overbruggingslening).88

Like a typical convertible loan, the loan accrues interest and is to be repaid or converted upon either maturity or a trigger event. The agreement includes a conversion discount, and it is possible to add a conversion cap.

After the conversion the lender has the right to the most senior class of shares outstanding at the moment of conversion or issued at the triggering event.89_{Certain debt covenants are} included in the agreements, these include prohibitions on paying dividends, distributing shares and obtaining other loans without consent of the majority of the lenders.90_{The loan is} automatically subordinated to any of the other creditors.91

84_{KISS: Debt Version, clause 2.3 and 1(a)(iii).}

V.B.2.

86_{Another example of this is the Seed Note by British law firm Cooley: Brad Newman, 'Series Seed Notes}

And Series Seed Equity Financing Documents' (CooleyGo) <https://www.cooleygo.com/announcing-new-series-seed-equity-and-note-financing-documents-and-generators/> accessed 4 June 2020.

87_{Maurits Bos, 'The Capital Waters Convertible Loan Agreements Are Now Online' (Capitalwaters.nl,}

2015).

88_{Evelien de Vries confirmed this in my phone call with her.}

89_{Capital Waters Convertible Loan Agreement April 2020 version (found on}

https://www.capitalwaters.nl/downloads/model-documents/), clause 1.1 and 4.1.

90_{Capital Waters Convertible Loan Agreement April 2020 version, clause 8.1.} 91_{Capital Waters Convertible Loan Agreement April 2020 version, clause 9.1.}

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3.5 Alternatives

There are really only two alternatives to using convertibles, and those are debt and equity investments, although they can be used under a wide range of terms. As of late, revenue-based financing (RBF) is gaining some attention in the startup world, but this financing method is still very new to the Netherlands and is therefore not relevant (yet) for the question at hand. 92_{However, due its potential to become the next big thing in startup financing, this} paragraph will briefly cover it.

3.5.1 Debt financing

3.5.1.1 Traditional debt

The biggest problem with debt financing is that is hard to get. Banks and other commercial lenders typically do not invest in startups because the lack of collateral and steady cash flows.93_{From the perspective of the founder, however, using debt financing has the big} attraction that she does not have to answer to the lender, as long as the debt is repaid on time and as scheduled.94

For a startup with fluctuating cashflows it is not always possible to make these payments, which would immediately result in default, in which case a secured lender could effectively shut down the business. Even if they are able to make the payments, these might better be used to invest in the growing business.

Additionally, startups might comply with any agreements made in debt covenants. These further restrict the startups flexibility and increase the ways a startup could default. Startups will also need to provide the bank with balance sheets and income statements, which could take up a lot time to make.95

92_{Sjoerd Mol, 'Revenue Based Financing: Investeren Op Basis Van Omzet, In Plaats Van Aandelen - Een}

Nieuwe Trend?' (Sprout, 2019) <https://www.sprout.nl/artikel/financiering/revenue-based-financing-investeren-op-basis-van-omzet-plaats-van-aandelen-een> accessed 6 June 2020.

93_{The report (paragraph 1.3) into the investment climate for tech startups shows that only 7% of founders}

tried to get funding from a bank in 2014, only 33% of those requests where granted. Founders where turned down because banks set too many requirements or founders could not show sufficient cash flows. Also: Seth C. Oranburg, 'Start-Up Financing', Start-Up Creation (2nd edn, Woodhead Publishing 2020), paragraph 4.2.2.

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3.5.1.2 Subsidies

There are some alternatives. In the Netherlands SME’s, located in the Netherlands and mainly operating there, can get a loan through microcredit or SME loans.96_{Entrepreneurs are} judged for their skills, like commercial ingenuity and perseverance.97_{Alternatively, startups} can use the SME credit guarantee scheme, if they have been active for at least 3 years.98 Younger startups can apply to the SME credit guarantee scheme (BMKB or durfkapitaal in Dutch), so that the government will act as guarantor for part (67,5% or 60%) of their loan.99 The startup will still need to find someone willing to finance, and the government will only act as guarantor to one lender.

3.5.1.3 P2P lending

If startups are not eligible for any of these options or if they are discouraged by for example the amount of paperwork, 100_{startups can turn to alternatives like peer-2-peer (P2P) lending} or crowdfunding. There are several problems with these options, besides that they might be time intensive to set up and complicated to manage. P2P loans often work with a reverse auction model, meaning the startup does not receive the funding until the loan is fully funded. Other downsides might include that the request for funding is visible to everyone.101

3.5.2 Equity financing

If the parties opt for equity financing, the investor will immediately get a share in the startup. The big advantage for the founder is that there is no loan to pay back, no risk of bankruptcy

96_{'Microcredit' <https://business.gov.nl/subsidy/microcredit/> and 'SME Loan'}

https://business.gov.nl/subsidy/sme-loan/, both accessed 6 June 2020.

97_{Translated from Dutch as these terms are not stated on the English website, ‘u heeft}

ondernemersvaardigheden, zoals commercieel inzicht en doorzettingsvermogen’.

98_{'SME Credit Guarantee Scheme (BMKB)' <https://business.gov.nl/subsidy/bmkb/> accessed 6 June}

2020.

99_{'Extra Steun Binnen De BMKB | RVO.Nl | Rijksdienst'}

<https://www.rvo.nl/subsidie-en-financieringswijzer/borgstelling-mkb-kredieten-bmkb/extra-steun-binnen-de-bmkb> (Dutch) or 'SME Credit Guarantee Scheme (BMKB)' <https://business.gov.nl/subsidy/bmkb/> (English). For tech startups that have a S&O statement (Speur- & Ontwikkelingswerk), the government is guarantor for 60% of a loan up to €1,5 million. The loan does not need to be payback until the 14th_{quarter after the loan was issued.}

First payment can be suspended with a year twice.

100_{For tech startups it is relatively easier to get subsidies, still only 13% of founders applied for}

government support. 70% of the requests were awarded in 2014. Only 43% has a positive impression of the role of the government, others thought that the information was unclear, inaccessible or overly complicated, and that the government is too slow and does not understand founders needs. Paragraph 1.5. The report does not include data on the use of the guarantor schemes, but the data does indicate that many tech startups do not apply for government help.

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and that all the money can be invested into growing the business. The founder and investor both have incentive to grow the company.

However, the founder will have to give up some of their control rights to the investor and might need to let them have a seat on the board. The investor typically gets preferred stock, which gives him the right to get paid first in acquisition, dividend payments and certain veto rights.102_{This can create frictions if the two have a difference in vision and can slow down} the decision-making process.

For early-stage startups, equity financing can be hard to come by. Investors prefer business models that can scale quickly, which are often software startups.103_{Just closing a deal is an} investment in itself, because equity investment deals are the most complex structure.104_Share purchase agreements are complicated and the average founders might fully understand the (monetary) implications of some of the provision.105

3.5.3 Revenue-based financing (RBF)

RBF is a type of financing that has become popular in 2019 and it is expected to start a new investing wave in the startup scene.106_{The first time this type of investing was used in the} Netherlands was in November 2019.107_{Revenue-based investors (RBI) give a loan to a}

paragraph 4.3.2.

paragraph 4.3.3.

104_{George Deeb, 'Comparing Equity, Debt And Convertibles For Startup Financings' (Forbes, 2014)}

<https://www.forbes.com/sites/georgedeeb/2014/03/19/comparing-equity-vs-debt-vs-convertibles-for-startup-financings/#2375361469ff> accessed 1 June 2020.

paragraph 4.3.3.

106_{‘I believe that Revenue-Based Investing (“RBI”) VCs are on the forefront of what will become a major}

segment of the venture ecosystem. Though RBI will displace some traditional equity VC, its much bigger impact will be to expand the pool of capital available for early-stage entrepreneurs.’ David Teten, 'Revenue-Based Investing: A New Option For Founders Who Care About Control' (Techcrunch, 2019) <https://techcrunch.com/2019/08/19/revenue-based-investing-a-new-option-for-founders-who-care-about-control/> accessed 6 June 2020.

107_{Maarten Keswiel, 'Nederlandse Startup Haalt Voor Het Eerst Een Investering Op Met Revenue-Based}

Financing' (Sprout, 2019) <https://www.sprout.nl/artikel/financiering/nederlandse-startup-haalt-voor-het-eerst-een-investering-op-met-revenue-based> accessed 6 June 2020.

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startup, which they are required to pay back by giving a fixed percentage of revenue until the loan plus a premium (the cap) is payed back.108

Founders retain ownership and control, without being tied to a debt that could push them into bankruptcy. The investor gets her money back faster109_{than she would have if she had} become a shareholder but does not get to enjoy the full potential upside a shareholder would. The investor is first in line if the startup is acquired and is guaranteed payment of the cap. RBF deals vary, with some RBIs getting rights to stock. The interest of the RBI and the founders are aligned because both benefit from a growth in revenue, at least as long as this does not stand in the way of (optimal) value creation.

RBF is interesting for startups that already have a (steady) stream of revenue and cannot get or do not wish to use equity financing. VCs are known for being somewhat sexist110_{, so this} might especially apply to women who have trouble getting financing or do not wish to give up control to some investor who does not respect them.111_{Startups that grow very rapidly and} have a clear exit strategy, might be better off sticking to VC capital.112

Chapter 4 Cause for regulation?

Any regulation of the convertible bond as a startup financing instrument could address two issues: the agency costs between the founders and the investor and in regard to the creditor. This chapter will discuss what regulatory action the legal rationale dictates these situations.

108_{David Teten, 'Who Are The Major Revenue-Based Investing Vcs?' (Techcrunch, 2019)}

<https://techcrunch.com/2019/08/19/who-are-the-major-revenue-based-investing-vcs/> accessed 6 June 2020.

109_{There is no data out there yet that shows that RBI have better returns, but they are expected to. See for}

example the calculation here: Allie Burns, 'Startup Investors Should Consider Revenue Share When Equity Is Bad Fit' (Techcrunch, 2019) <https://techcrunch.com/2019/01/29/startup-investors-consider-revenue-share-when-equity-is-a-bad-fit/> accessed 6 June 2020.

110_{This is not just an American problem; in the Netherlands a blacklist exists of investors who have treated}

female entrepreneurs in a sexist manner. Remy Ludo Gieling, 'Nederlandse Investeerders Schrikken Van ‘Misselijkmakend’ Seksisme Tegen Vrouwelijke Ondernemers' (Sprout, 2019)

<https://www.sprout.nl/artikel/investeerders/nederlandse-investeerders-schrikken-van-misselijkmakend-seksisme-tegen> accessed 3 June 2020.

111_{Allie Burns, 'Startup Investors Should Consider Revenue Share When Equity Is Bad Fit' (Techcrunch,}

2019).

112 _{‘Maar wel voor ondernemers die gaan voor gedegen en gestage groei. In de VS noemt men het ook wel}

‘Venture Capital for the rest of us’. Het is dus niet geschikt voor ‘pre revenue’ startups.’, Maarten Keswiel, 'Nederlandse Startup Haalt Voor Het Eerst Een Investering Op Met Revenue-Based Financing' (Sprout, 2019).

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4.1 Outside of insolvency: the agency problem between founders and investors

4.1.1 Legal rationale: protection of the weaker party

In the perspective of Dutch contract law theory, a balance should be struck between the freedom of contract and the protection of the weaker party. Freedom of contract is implicit in Dutch law and is codified in the European Charter of Fundamental Right in article 16.113 Freedom of contract can be limited by the law, for example declaring certain contractual provision void, or by a judge. In the Gorillapark case law for example, an appeal to an anti-dilution clause was deemed unacceptable under the circumstances.114

Protection of the weaker party is embedded in the Dutch Civil Code and is mandatory to individuals not acting within the scope of their enterprise of profession. The rationale behind this is a pessimistic one, in the words of Hartlief: ‘Consumers are – obviously – somewhat naïve and need to be protected against a tendency to be easily impressed and to act hastily and thoughtlessly.’115

Protection can also extend to an entrepreneur as the weak(er) party.116_{Houben notices a} trend away from freedom of contract to broader protection of the weaker party. Houben notices a trend away from freedom of contract to broader protection of the weaker party. Consumer protection laws can even be applied by the courts to entrepreneurs due to the so-called reflexwerking (consequential effect) of certain of these laws.

This protection of the weaker party in the error (dwaling) doctrine is also an important tendency in case law, an early example of this is the Baris/Riezenkamp case, in which the

113_{'Article 16 - Freedom To Conduct A Business' (European Union Agency for Fundamental Rights)}

<https://fra.europa.eu/en/eu-charter/article/16-freedom-conduct-business> accessed 7 June 2020, under tab explanation.

114_{Gorillapark [2002] Netherlands Supreme Court, ECLI:NL:HR:2002:AE2149 (Netherlands Supreme}

Court).

115_{Ton Hartlief, 'Freedom And Protection In Contemporary Contract Law' (2004), page 254. Hartlief calls}

this paternalism (page 256).

116_{Iris Houben, 'Autonomie In Het Contractenrecht: De Bescherming Van De Ondernemer' (2017) Ars}

Aequi

<https://openaccess.leidenuniv.nl/bitstream/handle/1887/54853/Autonomie_in_het_contractenrecht.pdf?se quence=1> accessed 7 June 2020. Recent examples of laws offering protection of the weaker party are: the protection SME entrepreneurs in swap deals with banks, acquisition fraud and franchising. This type of protection was historically primarily aimed at natural persons. She stresses that restraint is important in extending this protection, but that protection does not necessarily mean that the parties autonomy is restricted. Protection for certain entrepreneurs can be justified as long as the measures are clear and coherent.

The convertible loan: startup’s friend or foe? - An inquiry into the need for regulation of the convertible loan in Dutch tech startups