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February 2, 2024
7 min read

The guide to convertible loans for startups

All you need to know about convertible loans.

They transform debt into equity and provide a fast financing solution for startups: convertible loans. What do young companies need to know about this form of financing?

Startups require capital at various stages: when starting their business, for further growth, or between funding rounds. However, securing funding from venture capital funds is time-consuming and challenging. And it has become much more difficult these days.

In this case, convertible loans can become a relevant option. They provide a solution for startups to finance themselves, and allow investors to make an investment without valuing the company.

In this article, we will explain what convertible loans are, the essential role of company valuation, the different elements of a convertible loan contract, and what founders should consider beforehand.

re:cap_Convertible Loans_Overview
Convertible loans: three important aspects about this financing instrument.

What is a convertible loan?

Imagine a startup in its early stage. It has minimal to no revenue, not yet achieved product-market fit, and an unproven business model – making its future challenging to evaluate.

Due to these uncertainties, the company's value cannot be precisely determined. Everything depends on positive outlooks for the future. Convincing VCs and business angels to invest in this situation can be a challenge.

Yet, the startup urgently needs capital. Its runway is only a few months. It requires bridging with fresh capital until the next funding round.

A convertible loan transforms debt into equity

This is where a convertible loan as an alternative financing option comes into play. Convertible loans are loans through which startups receive debt capital – but with a particular feature.

A convertible loan grants lenders the right to convert debt into equity at a later date, typically during the next financing round.

Startups quickly obtain capital, investors reduce their risk

Startups gain rapid access to capital, much faster than with other sources of financing. They typically use a convertible loan for:

  1. Seed funding: To make necessary investments and boost growth.
  2. Between funding rounds: To extend their runway, enabling them to reach the next round and secure fresh capital.

However, the quick access to capital comes at a certain cost of capital. Initially, startups take on debt that they theoretically need to repay. If the debt is converted into equity, the investors acquire company shares at a significantly lower price than new investors. This leads to a higher dilution of company shares.

On the other hand, investors with a convertible loan engage in a certain risk mitigation. In the initial phase, they only provide debt capital with a fixed term, interest, and repayment rates. The risk is more manageable than with an equity investment. Debt capital can later be converted into equity, depending on whether the conversion was set as a right or obligation in the contract.

re:cap_Convertible Loan_investor
Convertible loan from an investor's perspective.

Characteristics of convertible loans

Convertible loans are quickly executable

Months of analysis and negotiations with investors about a company's fair valuation? All of this is initially set aside when it comes to convertible loans.

The involved parties require only minimal information to make a decision. Convertible loans are often an instrument through which existing investors provide additional fresh capital. They are familiar with the startup and have already evaluated it closely during their initial investment.

When founders are in discussions with investors regarding financing, the company valuation plays a crucial role. The value of a share determines how many shares a company must give up (dilution) and the amount that investors will invest in the company.

In the case of convertible loans, this is not foreseen. Company valuation is not part of the negotiations. The involved parties await the next financing round, during which the lenders will base their valuation on the valuation determined at that time.

This speeds up the process and makes convertible loans a relatively quick-to-implement financial instrument.

Contracts are easy to draft

Typically, it only takes two to five pages to draft a convertible loan agreement. In the case of a VC funding, it can involve up to 50 pages. This also positively affects the costs associated with drafting such contracts, as it doesn't require lawyers or notaries.

Such a convertible loan agreement includes:

  1. The loan agreement
  2. Information about the conversion process
  3. Investor's rights
  4. Provisions regarding subordination

In particular, the rules for conversion and investor rights are essential components of this contract. We will delve into each of these components in detail below.

Convertible loans are flexible

Repayment at the end of the term? Interest-free period? Height of the conversion discount? Valuation Cap? All of these elements can be flexibly tailored to suit the needs of the parties involved. That makes convertible loans relatively flexible. The interests of startups and investors can quickly align.

Funding amounts are typically smaller

The granting of million-euro amounts is rather rare with convertible loans, at least in the early stages of a startup. Funding amounts typically range from €100,000 to €500,000. Due to the uncomplicated nature of the contract, startups can also finance themselves with several convertible loans, each for smaller amounts. However, convertible loans are not only interesting for early-stage companies but also for startups in the growth phase.

Convertible loans are both debt and equity

A convertible loan is an alternative financing instrument, sitting between debt and equity. It represents a blend of both and, therefore, it’s characterized as mezzanine capital. Banks treat it as "equity-like," which positively impacts the company's creditworthiness.

The pros and cons of a convertible loan

Advantages of convertible loans

  • Quick access to capital for startups.
  • Flexible and uncomplicated contract structure.
  • Low costs associated with contract drafting.
  • Interest and repayment typically occur at the end of the term, minimizing the impact on the startup's cash flow.
  • The startup's credit line increases, as banks view the convertible loan as "equity-like."
  • Lenders do not have voting rights in the company until conversion.

Disadvantages of convertible loans

  • Convertible loan lenders offset their risk by receiving a high discount (20 to 30%) on the next company valuation.
  • Depending on the contract's structure, a valuation cap can result in capital providers acquiring more shares at an even lower price.
  • A convertible loan does not automatically mean that debt capital will convert into equity. If not, the company must repay the loan including interest.
  • Convertible loan providers are typically considered silent partners – they rarely contribute their expertise and network to the startup.

What the convertible loan agreement contains

As mentioned earlier, a convertible loan agreement can be drafted relatively quickly. Here are its key components:

re:cap_convertible loan agreement
Key components of a convertible loan agreement.

Loan agreement

Contains provisions related to loan disbursement, including: 

Timing of disbursement

Is the disbursement made all at once?

Is the disbursement made in tranches?

Are there any milestones attached to the disbursement?

Time period

The duration of a convertible loan is typically short, usually ranging from one to three years.

Interest rate

How high is the interest rate?

Is there a grace period? 

Repayment terms

How high is the repayment rate?

Is the repayment rate paid regularly (e.g., monthly) or at the end of the term?

Conversion

Describes the conditions under which debt can be converted into equity or a company shareholding.

Key elements of the conversion include:

  1. Whether it is a right or obligation for the investors.
  2. The formula for calculating the shares investors receive.
  3. Information about the valuation discount and valuation cap.
  4. A mechanism to secure the conversion, which may involve commitments from the company or the founders or management.

Investor rights

Investor rights outline the rights granted to investors, such as participation in decision-making, access to information, or other privileges like liquidation preferences (distribution of exit proceeds).

Subordination

Convertible loans typically come with a qualified subordination clause. In the event of insolvency, the repayment claim of convertible loan lenders is placed at the very end of the list of creditors ("subordinated"). This is because investor claims are treated as equity, and thus not considered a liability of the company.

The process behind a conversion

Several steps precede the conversion of debt to equity. These include:

Shareholder resolution to conclude a convertible loan agreement

To enter into a convertible loan agreement, a shareholder resolution is required. This typically requires a simple majority in the shareholders' meeting, usually composed of the founders (in the case of a startup).

Execution of the convertible loan agreement

With the approval of the shareholders' meeting, the convertible loan agreement can be executed. The startup receives capital, and the loan becomes effective. Companies can find a standard contract for this at the German Startups Association.

Capital increase resolution

At the end of the contract term, investors have the right or obligation to convert their loans into company shares. A capital increase is necessary because the company must issue additional shares. Within the shareholders' meeting, this resolution requires a 75% approval.

Final conversion

After the capital increase, the former investors become shareholders of the startup. This is when the calculations for the valuation discount or valuation cap come into play. But what are the mechanisms behind those terms?

Valuation discount and valuation cap: differences and calculation

The valuation discount determines the discount that investors receive on the shares. This means that they pay less per share than new investors. This discount usually ranges between 20 to 30%.

The valuation cap is the maximum company valuation at which debt capital converts into equity. For example, if the convertible loan providers set the Valuation Cap at €5 million, but the startup is valued at €10 million in the next financing round, the convertible loan providers will convert at the predetermined valuation of €5 million.

However, the valuation discount and Valuation Cap typically do not apply together. The parties contractually agree in advance that the convertible loan providers must choose one of the two instruments at the time of conversion.

Calculation of a convertible loan with a valuation discount

Initial situation: A startup founder holds all 100,000 company shares.

An investor enters with a convertible loan
  • The investor offers funding through a convertible loan of €100,000.
  • The loan includes 8% interest with a one-year term.
  • Repayment and interest are due at the end of the term.
  • The convertible loan has a 20% valuation discount, applicable during the next financing round.
  • There is no valuation cap.

A new VC funding round occurs one year later
  • A venture capital fund enters with €500,000.
  • The company valuation is €5 million.
  • €5 million / 100,000 company shares = €50 per share.
  • €500,000 / €50 per share = The VC acquires 10,000 shares.

Simultaneously, the convertible loan takes effect.
  • €100,000 repayment + €8,000 interest = €108,000 debt capital.
  • €50 per share – 20% valuation discount = €40 per share for the convertible loan provider.
  • €40 per share – €1 nominal value per share during the capital increase = €39 per share as conversion price.
  • €108,000 / €39 per share = 2,769 shares for the convertible loan provider.

Example calculation of a convertible loan with a valuation cap

Initial situation: A startup founder holds all 100,000 company shares.

An investor enters with a convertible loan
  • The investor offers financing through a convertible loan of €100,000.
  • The loan includes 8% interest with a one-year term.
  • Repayment and interest are due at the end of the term.
  • The convertible loan is set with a Valuation Cap of €3 million.
  • There is no discount on the valuation.

A new VC funding round occurs one year later
  • A venture capital fund enters with €500,000.
  • The company valuation is €5 million.
  • €5 million / 100,000 company shares = €50 per share.
  • €500,000 / €50 per share = The VC acquires 10,000 shares.

Simultaneously, the convertible loan takes effect.
  • €100,000 repayment + €8,000 interest = €108,000 debt capital.
  • €3 million Valuation Cap / €5 million company valuation = 0.6 valuation cap.
  • €50 per share * 0.6 valuation cap = €30 per share for the convertible loan provider.
  • €30 per share – €1 nominal value per share during the capital increase = €29 per share.
  • €108,000 / €29 per share = 3,724 shares for the convertible loan provider.

In this scenario, the valuation cap can serve as an incentive for investors to participate in a startup as early as possible and take on the additional risk.

FAQs

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How do SaaS companies work?

SaaS stands for Software-as-a-Service and refers to a licensing and distribution model by which companies offer software solutions online as a service.

What growth stages do SaaS companies go through?

After the preparatory early-stage phase, the product goes live, becomes better known, and establishes itself in the market, before the customer base ideally expands significantly and finally either a company sale, a merger, or further growth takes place.

Why is revenue financing ideal for SaaS companies?

In the important second growth phase, when SaaS companies are already on the market and generating recurring revenue, revenue financing provides flexible SaaS funding based on the ARR without dilution or loss of control.

What is ARR?

ARR refers to annual recurring revenue. Specifically, in the subscription economy, ARR refers to the annual value of regular revenue generated through subscriptions.

What does ACV mean?

ACV stands for Annual Contract Value and in a SaaS business, it refers to the average annual value of a subscription - i.e., the holistic contract value excluding one-time fees divided by the contract term in years.

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What is a corporate loan?

As a counterpart to the personal loan, the corporate loan serves entrepreneurial purposes - as a short-term cash injection for liquidity needs or as an investment for long-term growth. Entrepreneurs use the borrowed capital, for example, for new personnel, a larger office, marketing, better hardware, or the company's establishment.

What kind of business loans are there?

A short-term business loan runs for a few months or years, while a long-term loan runs for several years. If a company needs capital quickly, an overdraft is an excellent short-term loan financing option - there are not many conditions to be met for this, as the principle is similar to an overdraft.

What are the providers of business loans?

There are many providers of business loans. Three overriding types come into focus:
- via the principal bank
- state-subsidized
- digital solutions
The first way is via the branch banks. The options are diverse, whether long-term or short-term credit, investment or working capital credit, just like the linked conditions. Subsidized corporate loans are also run through the house bank, but regional or nationwide development banks (such as KfW) are involved here.
Modern solutions come from FinTechs that specialize in smart financing. Whether credit or alternative, this is where startups and large companies meet technology-savvy innovators of the digital age.

What is the advantage of corporate loans?

A corporate loan is usually available quickly. In addition, because it is debt financing, founders do not have to give up control as well as company shares and do not have to share profits with lenders.

What is the disadvantage of business loans?

Business loans come with interest and are often tied to a specific purpose, so entrepreneurs are limited in how they can use the capital. It is also usually a restrictive concept with strict repayment terms, warrants, and very little flexibility - which is why many companies are looking for a suitable loan alternative.

How do credit and loans differ?

Some refer to short-term financial assistance and a smaller amount as a loan and to longer terms and higher capital as a loan. However, the terms are usually used interchangeably.

What are the interest rates on corporate loans?

They can be less than 1% or in the double digits. The credit rating determines this: the higher the risk class, the higher the interest rates. The amount of capital, term and any collateral also determine the interest rate. Therefore, it is always a good idea to compare different corporate loans.

Who grants corporate loans?

Companies can obtain the traditional loan from their principal bank - a government subsidy via federal or regional development banks is also possible. Modern variants come from FinTechs, which use technology-driven solutions for smart financing.

What are the alternatives to corporate loans?

Various financing solutions work with equity and debt. With equity financing such as venture capital, founders lose valuable company shares and often have to give a say. A particularly smart alternative to corporate loans and equity financing is non-dilutive, non-restrictive and very flexible turnover financing.

What is the best credit alternative?

There is no all-comprising answer to this question, as financing is always an individual solution. However, recurring revenue financing is increasingly establishing itself as a particularly attractive and popular alternative to loans and equity financing.

What makes re:cap stand out as an alternative to loans?

With re:cap, SaaS companies can obtain growth capital very easily and quickly - up to 50% of ARR. The innovative funding works with planned revenues and also flexibly aligns repayments accordingly. In addition to on-demand financing, re:cap offers valuable insights and benchmarks on request.

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What does debt financing mean?

In debt financing, companies receive a certain amount of money from an external investor. The company holds the debt capital for a limited period and must be repaid - usually with interest and within a fixed time duration.

What does debt capital include?

Debt capital includes typical liabilities of a company, such as loans, bonds, and provisions, as well as unique forms like deferred income.

What are examples of debt financing?

There are various types of debt financing, which can basically be divided into short-term and long-term debt. Unique and mixed forms are also possible - examples:
- Short-term: overdraft, trade credit, acceptance credit
- Long-term: promissory note loans, bonds, long-term bank loans
- Special form: leasing, factoring, asset-backed securities
- Mixed form: mezzanine as a mix of equity and debt financing

What is short-term debt capital?

Short-term debt capital is provided to companies for a short period of time - repayment usually takes place within a few months. Such capital is primarily used to meet short-term liquidity needs.

What is long-term debt?

Long-term debt capital is provided to companies for a longer period of time - repayment usually occurs within several years. The capital is used for investments.

What is the difference between equity and debt financing?

From the perspective of the capital providers, it is primarily a question of liability because, in the case of equity financing, capital providers are liable for entrepreneurial activities. In return, they usually receive a share and benefit directly from the profits. Because founders relinquish shares and entrepreneurial control, this is referred to as a dilutive type of financing. This is not the case with debt financing, which involves interest and is generally more restrictive.

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How can I finance my startup?

From bank loans to private savings to equity financing: There are many ways to finance a startup - through external providers and your own capital. As a novel and popular solution, so-called revenue financing is also becoming more and more established in Germany.

Which companies fund startups?

In addition to investment companies from the venture capital segment, there are innovative FinTech companies such as re:cap. They innovate to create modern funding solutions. re:cap enables companies in the subscription economy to trade future revenues for on-demand, non-dilutive capital. Fast, transparent and easy.

Who is startup funding with re:cap suitable for?

The funding solution from re:cap is specifically aimed at subscription companies that reach a growing customer base with their already launched product and generate predictable, recurring revenues. In addition, the legal entity must be at least partially located in the EU.

How quickly can I get startup funding?

As long as you are within your financing limit, you can access new funds as often as you like. The financing limit will be increased based on the growth of your business and the track record on the re:cap platform.
The funding will typically arrive in your bank accounts within two business days once it gets approved.

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What is working capital?

Working capital is also called operating working capital. It is the difference between current assets and current liabilities and, as a balance sheet ratio, provides information on companies' capital stock and financial strength.

What does working capital tell us?

The working capital figure shows which funds are tied up in regular company operations - it can also be used to determine whether working capital financing is necessary.

Is high working capital good or bad?

A positive value shows that current assets can cover current liabilities - this is important in terms of the golden rule of the balance sheet. A negative value conveys a risk, because affected companies are considered to be illiquid. This can lead to financial bottlenecks.

Can working capital be too high?

The question of working capital levels is answered differently depending on the company or business model - especially across industries. However, working capital levels that are too high often indicate that working capital is being used less wisely and that too much cash is being tied up.

What are examples of working capital?

In business management, working capital is usually indirect and long-term goods that companies need for their products and services. A distinction is made between tangible resources, such as warehouse and office space, and intangible ones, such as licenses.

How does working capital financing work?

Working capital financing allows companies to increase their working capital and generate positive value. It provides them with short-term cash to pay liabilities or make investments.

What are the different working capital options?

Working capital financing is multifaceted. Depending on the industry and business model, various types may therefore be considered, such as drawing on the credit line, receivables credit, factoring, and inventory lending. Increasingly popular are alternative solutions such as non-dilutive and non-restrictive sales-based financing.

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What is a convertible loan?

The definition of a convertible loan is simple: it is a normal loan in which the company does not repay the borrowed amount after the expiration of the term, but converts it into company shares. It is therefore technically a combination of both equity and debt.

How does a convertible loan work?

The following scenario is a typical example of a convertible loan: A company receives capital with a predefined interest rate. The parties agree on a term and also a discount on the company's shares, which acts as a risk compensation. At the end of the term, the investor receives the shares in the amount of the convertible loan plus interest - so-called qualified capital for the company.

How high are convertible loans?

Usually, convertible loans are around 100,000€ - but they can also be up to 400,000€ and more. To collect as much capital as possible, start-ups often arrange several convertible loans with different investors.

What should a convertible loan agreement regulate?

In principle, there is freedom of contract here - a convertible loan agreement is therefore not subject to any legal rules. The following components are the basis: the amount of the loan, the interest rate and discount, and the term. In addition, some parties agree on a cap (maximum valuation) or a floor (minimum valuation). Subordination is also included in many convertible loan agreements.

What is an alternative to the convertible loan?

Founders can obtain convertible loans quickly and easily and use them flexibly. These advantages also characterize re:cap's convertible financing. However, convertible financing involves giving away shares. This is not the case with re:cap's solution, which is non-dilutive funding for sustainable growth. Therefore, it is an ideal alternative to the convertible loan.

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Is crowdfunding free of charge?

No. In case of success - i.e. if your project reaches its target budget - you pay platform and transaction fees between 4 and 12 percent to the crowdfunding platform. The exact amount depends on the platform. If your campaign fails, you pay nothing.

Why is crowdfunding so popular?

Crowdfunding brings many advantages. The fact that the legal form and creditworthiness of the project do not play a role in crowdfunding certainly plays a major role in its popularity. Thus, especially creative people and artists of all kinds, as well as non-profit initiatives, can collect money for their projects. The positive marketing effects, as well as customer proximity and loyalty, also ensure the good reputation of crowdfunding.

Who is crowdfunding suitable for?

Crowdfunding originates in the artistic sector for financing various creative projects in the fields of music, film, theater, and art. Today, however, it is also used by private individuals, non-profit organizations, and companies of all kinds - whether in the startup phase or as a boost in ongoing operations.

What are the different variants of crowdfunding?

There are four types of crowdfunding, which differ primarily in the consideration:
1) In equity based crowdfunding, investors receive returns on their investments.
2) In reward based crowdfunding, the initiators provide non-cash or intangible compensation for the investment.
3) In donation based crowdfunding, investors donate their contribution.
4) In lending based crowdfunding, the investors grant private loans with a fixed interest rate to the initiators.

How do I receive crowdfunding?

Whether you are a startup or a medium-sized company: crowdfunding can theoretically be 'applied for' by anyone. However, success depends on how many investors are convinced by the project. Anyone who wants to try their hand at crowdfunding must first create a campaign on one of the common crowdfunding platforms and advertise it on their own channels.

Does crowdfunding make sense?

Crowdfunding offers particularly many advantages for private, non-profit, and creative projects - or as a supplement to public funding. In addition, crowdfunding can be particularly worthwhile for early-stage startups that have largely completed their product development and now need fresh capital for growth. Young companies that want to test their business model or product can also benefit from the communication and participation of a crowdfunding campaign - providing an indicator for other forms of financing.

Is crowdfunding proprietary or debt financing?

Crowdfunding is financing based on debt capital. The capital provided comes from a large number of investors, mostly private individuals and companies - the so-called crowd or swarm. Hence the term 'crowd financing'.

What are the alternatives to crowdfunding?

Crowdfunding is considered an alternative financing option, which is opposed by several common alternatives (or supplements). Among them are public funding, corporate credits, venture capital, or even founder competitions. Newer forms of financing, such as re:cap's recurring revenue financing, offer another alternative to crowdfunding.

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What is factoring?

The definition of factoring is simple: to quickly receive the money from open invoices and generate liquidity, companies hire a factor who settles the outstanding payments as an advance and takes over the accounts receivable management. It is therefore a sale of receivables.

How does the selling receivables work?

The factor checks the verity of the invoice and the creditworthiness and default risk of the debtor. Then the factor pays the majority of the outstanding invoice amount to the contracting company, usually within 48 hours. After the factor has collected the receivable from the debtor, the company receives the remaining gross amount that the factor has retained as security.

What types of factoring are there?

Anyone interested in factoring should take a closer look at their options because there are differences. In recourse factoring, the factor bears the full risk of default. Less secure - from the point of view of the selling company - is non-recourse, in which there is no protection against bad debts. If companies do not want their customers to know about factoring, they can choose the silent option.

What are the risks involved in factoring?

Since there is a large number of factoring companies, companies can quickly end up with a provider whose credit rating itself is weak. However, the performance of a factor is not always directly apparent. In the worst case, the assigned factor goes insolvent and the company loses a lot of money. In addition, some customers see it as a sign of mistrust if it is not the company providing the service that demands payment but a third party unknown to them - this could be circumvented by silent factoring.

What are the costs of factoring?

There is no single answer to this question because the fees are very opaque - based on various key business figures. In addition, the total costs are not only made up of a clearly defined factoring fee but of several items. Interest often accrues as well.

What are the most popular alternatives to factoring?

TexSince factoring is revenue-based financing, other revenue financing options are also great alternatives to factoring. This is also true for re:cap's solution - it is tailor-made for companies with a subscription business model that generate predictable, recurring revenue.t

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What are venture capital alternatives?

Venture capital is not suitable at all times - and not for every type of company. Common alternatives are:
- Venture debt (hybrid debt financing),
- Founder competitions,
- Government subsidies
- or alternative forms of financing,such as crowdfunding.
Companies with subscription business models can also exchange their future revenues for immediately available capital - with re:cap financing.

When is venture capital worthwhile?

Generally for founders and entrepreneurs in the growth phase. But not every startup is attractive to investors. Venture capital funding is worthwhile when the business idea is innovative, the sales argument is clearly recognizable, and the founding team is convincing. In addition, the market must promise growth.

How do I get venture capital?

Private venture capitalists, also known as business angels, and so-called venture capital companies provide equity capital. But not just like that. If you want to go into fundraising, you have to be convincing. Prerequisites are a watertight pitch, a realistic understanding of the current company valuation, the amount of capital needed and the time frame in which the capital is needed.

How does venture capital work?

Venture capital is a form of private equity financing in which venture capital companies provide capital to promising unlisted companies in exchange for a stake in the company. Those who want to grow their company with venture capital must first contact investors and convince them of the company's merits.

How long does venture capital take?

Often several months pass between the start of fundraising and the receipt of venture capital. The pitch only follows after the founding team has identified potential investors. Afterward, the company is preliminarily reviewed by the potential investors. If this goes well, a term sheet is signed, followed by due diligence. The capital will flow only when the investment documentation has been completed.
If you can't or don't want to wait that long, you can look for alternative forms of financing like the one offered by re:cap. With re:cap you can bridge the time to the next round and thus, optimize the upcoming financing round. At the same time, this increases your options when looking for investors.

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What is alternative financing?

These are forms of financing that companies can use as an alternative to established models such as loans - they are often modern solutions that are quickly and easily available digitally.

What are the different types of alternative financing?

The market for alternative financing options is growing, so companies can already choose a model that suits them individually. The better-known ones include convertible loans, factoring, crowdfunding, and venture debt. Alternative debt instruments, including recurring revenue financing or revenue-based financing, which have been successfully established in the U.S., are still rather new in Germany but becoming increasingly well-known and popular.