Early-stage startups often face a significant challenge due to their very limited runway – as usually they burn money faster than they are able to acquire funding – which makes external capital crucial for sustainability. From the perspective of potential investors determining the worth of these startups is a key factor in deciding whether to invest or not into the specific project which is complex and time consuming, a luxury startups often lack.
To address this issue, the venture capital market has already devised specific tools, such as the SAFE (Simple Agreement for Future Equity) and – the subject of the present article – the convertible notes. Both instruments are already implemented by several countries with advanced startup ecosystems to facilitate early-stage investments for innovative startups while ensuring adequate protection for investors.
Both the SAFE and convertible notes defer the pricing of the investor’s stake until a later date, usually the first priced investment round. However, a significant distinction lies in the convertible note’s nature as a debt instrument. It carries a maturity date, and if no first investment round occurs by then, the investor can choose between debt repayment with accrued interest or conversion as per pre-specified terms in the convertible notes agreement.
The convertible notes agreement stipulates various financing terms, including a maturity date, the interest rates, conversion events and discounts during the first investment round. This discount might involve a valuation cap for conversion into equity or a discounted rate for determining the goodwill in the first investment round before the number of shares are determined.
As of September 1, 2023, Hungary has implemented principles for providing convertible notes, a long-awaited milestone for the venture capital market. This move, however, hasn’t yet included the implementation of SAFE agreements.
Prior to that, investors had the option to make a capital investment, which are suited for startups in their growth stage because they involve a complex negotiation and documentation process, or to provide loans with the option to convert into equity, similar to convertible notes. However, the Hungarian regulatory system requires a supervisory authorization from the Hungarian National Bank for commercial credit or loan granting, a burden for potential investors.
However, the new legislation enables investors to provide convertible notes without such supervisory authorization, if the following criteria are met:
- an investor may enter into fifteen convertible note agreement in a calendar year;
- the investor’s total convertible note stock shall not exceed HUF 500 million for individuals and HUF 2 billion for legal entities;
- limiting the convertible notes only to micro and small enterprises established within five years, which are not publicly listed, have not yet paid dividends, or were not formed through merger or division.
While the implementation of convertible notes alone might not drastically impact the startup ecosystem, there is optimism about the government’s willingness to co-operate with the market to introduce further foreign startup-specific practices, which could boost Hungary’s venture capital market to thrive.
By Peter Ruff, Senior Associate, Pontes Budapest, Pontes
