Convertible Notes: What They Are and How They Are Applied in Turkish Law

When it comes to early-stage investments in the entrepreneurship world, flexible financing models are crucial for both investors and founders. This is where the Convertible Note comes into play. So, what exactly is a Convertible Note, and how is it applied in Turkey?

What is a Convertible Note?

A Convertible Note is a financing instrument based on the principle that an investor provides a loan to a startup company, and this debt is subsequently converted into equity (shares) in the company. Thus, the investor supports the company's growth while simultaneously acquiring the right to become a shareholder in the future.

This system is particularly used during seed funding rounds where the company's valuation is not yet clearly established. The investor provides the loan before the company's valuation is determined, and the conversion into shares takes place in later stages. This balances the risks and rewards for both the investor and the entrepreneur.

How Do Convertible Notes Work in Turkey?

Since Turkish Law imposes restrictions on companies acquiring their own shares, Convertible Note agreements are typically structured within the framework of a loan agreement.

In practice, the investor grants a loan to the company and is usually made a symbolic partner with 1 share. Subsequently, when the conditions stipulated in the agreement are met (the triggering event), the debt is converted into new shares belonging to the company.

With regulations introduced in 2020, foreign currency denominated Convertible Notes became applicable in Turkey under certain conditions. This enables early-stage companies to secure fast and flexible financing from foreign investors.

Key Elements of a Convertible Note

Convertible Note agreements are generally shaped around a few core elements. Primarily, the Valuation Cap serves to mitigate the investor's risk by predetermining the maximum valuation of the company at the time of conversion. Additionally, the Discount Rate secures the investor’s right to acquire shares at a discounted price during the subsequent financing round (the Qualified Financing Round). The loan’s Interest Rate can affect the conversion or cash repayment amount. Finally, the Maturity Date specifies the time when the debt is subject to conversion or repayment. The accurate reflection of these elements in the agreement ensures a transparent and balanced relationship between the investor and the entrepreneur.

Advantages and Risks

Convertible Notes offer various advantages for entrepreneurs and investors. Companies can quickly secure early-stage financing, while investors acquire shares at an advantageous price due to the Valuation Cap and Discount Rate. The short negotiation period and the flexible nature of the process provide additional ease for the parties. Conversely, there are also some risks. For example, if the triggering investment round does not materialize, repayment of the debt could become an issue. Furthermore, if the agreement details are not meticulously prepared, there is a risk of a dispute arising in the future. Therefore, securing legal consultation when utilizing a Convertible Note is critically important.

Conclusion

The Convertible Note is a flexible and effective financing model for early-stage ventures, benefiting both the investor and the founder. While not a direct statutory type of contract in Turkey, it can be successfully implemented within the framework of a loan agreement.

If you are considering using this model as an investor or entrepreneur, the preparation of the agreement and its terms, in consultation with a specialized legal advisor, is crucial. When structured correctly, the Convertible Note can be a powerful tool in your entrepreneurial journey.

This content is intended for general informational purposes only; it does not constitute professional legal advice regarding specific cases.