What is a convertible loan note?

If you’re a start-up or investor, you’ve likely come across convertible loan notes. But you may be wondering what they are exactly and how they benefit small businesses?

A convertible loan note (also known as convertible debt or a CLN) by definition is a type of short-term debt that is converted into equity later down the line. The convertible loan note is therefore a financial instrument that outlines the debt owed to the lender.

Put simply: a convertible loan note in the UK is a loan that an investor can provide to a start-up. However, there is one key difference.

In contrast to a typical loan that’s taken out with the intention of being paid back, a convertible loan note is not awarded with the same intent – in the traditional sense at least.

Instead, the note will convert to ownership in the company (typically stocks and shares). These shares will usually be of equal cash value to the initial loan.

Is a CLN debt or equity?

When accounting for convertible loan notes, you’ll need to know whether it is debt or equity. Seemingly unhelpfully, a convertible loan note is a hybrid of both debt and equity.

For accounting purposes, all convertible loan notes begin their life as a debt but will convert to equity eventually. The point at which they do so is known as the ‘trigger’, which we will come back to shortly.  

H2: What are the different types of convertible loan notes?

There are two different types of convertible loan notes: secured and unsecured.

Secured CLNs

Like a mortgage, a secured convertible loan note requires you to put up assets as collateral should you fail to repay the loan.

Especially in the case of start-ups, this makes sense for investors as there’s no guaranteed way of telling how a business will do. This makes the investment risky for an investor.

To make the prospect more appealing, a secured loan offers more protection to the investor. This type of CLN is also known as a debenture agreement.

Unsecured CLNs

The second type of convertible loan note agreement is the unsecured variety. These are generally much simpler by nature. To create one, there are a few steps to take:

• The company, founders and investors will consent to the convertible loan note agreement.
• The investors are then called ‘loan note holders’.
• Money is sent to the company by the investor(s).
• A promise is made by the company to pay the investor back or issue shares equivalent to the loan amount.

Why are convertible loan notes more attractive to investors?

A convertible loan note is a cash investment that is later converted to shares. Yet you may still be wondering what makes that so attractive to investors.

In short, investing in the form of a CLN usually allows the investor to receive the company shares at a discounted rate based on the company’s future valuation.

For example, if investors give your business a valuation of £5 million and your business has 5 million shares, this would mean that each share is worth £1. Now, if your investment was made through a CLN that stated that the discount would be 20%, the note would entitle the investor to the preferential rate of 80p per share, rather than the market value of £1.

Therefore, by investing through a convertible loan note, the investor gets a better deal.

However, the exact discount and parameters are decided by the terms of the convertible loan note agreement.

What are the key terms of a CLN?

Key to a convertible loan note is knowing what happens when. That’s where the key terms come in. Although they can differ in each agreement, some common terms are usually included.

The trigger

When a company raises equity beyond a pre-agreed threshold, this will trigger the conversion of the CLN into equity. Put simply: the debt will be redeemed in the value of shares.

Maturity date

This is the date the loan amount and interest is due, should the trigger event not have occurred. Typically, this is 3-5 years from the initial agreement.

The investor has three options if the trigger has not occurred at the maturity date:

1. Call the loan – The investor may demand back the money owed. This usually doesn’t happen as it would be unlikely the business would have the funds to pay it back in full.
2. Extend the loan – Following negotiation, the investor may extend the loan. However, they will usually want better terms as they are waiting even longer to receive their cash.
3. Optional conversion – Written in the note there will be a predetermined valuation. If the investor chooses, they can convert the cash to shares even if the trigger is not reached.  

Principal and interest

This sets out the interest rate of the conversion loan note, while the principal amount is the total amount due on the maturity date.

Event of default

Should you be unable to pay back the interest in time, or you breach the agreement, you will reach a point called the ‘event of default’.

At this stage, negotiations begin between the company and investor to decide on the next steps.

Should this happen, your company could be taken over by the note holder. 

The conversion discount

To reward investors for the risk they have taken in investing, they will be offered a conversion discount. Essentially, this is a preferential rate (or discount) on share and stock prices.

The discount is usually between 10-20%.

Valuation cap

A way to reward seed-stage investors, the valuation cap sets the maximum price at which your convertible loan note will convert into equity.

A cap means that if you get a valuation above the cap, the price per share is determined by the cap rather than the valuation. So, using the same example as previously, if you put a £3 million cap on a company with 5 million shares at £1 each, each share would be bought by the investor for 60p.

This, therefore, gives a better rate for the investor than a standard discount, which would equate to 80p per share. Both options will give investors a better rate than the hypothetical market value of £1 per share.

Most favoured nation cap

This could arise if your business is booming and you raise more money than the future valuation. Fundamentally, if future investors get a better rate than the CLN holders, the note holders will have the right to switch to the more favourable terms.

Any other terms

The convertible loan note can also contain any other terms agreed by both parties. This may include additional rights of the investor. For example, the investors may wish to have information or approval rights.

H2: What happens if the company is sold before a CLN is converted into shares?

If the company is sold before the trigger event, the investor will be paid ‘2X’. This means the investor will be paid:

• 2 x the note value
• 2 x the interest
• A quick cash injection – In the early stages of business, full funding rounds may not be achievable. A convertible loan note, therefore, offers a quick way to raise funds.
• Lower legal costs – Convertible loan notes are relatively straightforward from a legal perspective, meaning lower legal costs. 
• More control for the founders – Ordinarily, the note holders will only seek minimal rights to the business (for example, information rights). As the investors will only become a shareholder later down the line, the founders will be spared from granting shareholder rights to the investors until the conversion. This makes business decisions easier.
• Convertible loan notes avoid placing a valuation on the start-up – This is particularly beneficial for seedling companies with limited operating history.  

What are the benefits of a convertible loan note?

Convertible loan notes are a popular way of receiving investment. Some of the advantages for start-ups include:

• A quick cash injection – In the early stages of business, full funding rounds may not be achievable. A convertible loan note, therefore, offers a quick way to raise funds.
• Lower legal costs – Convertible loan notes are relatively straightforward from a legal perspective, meaning lower legal costs. 
• More control for the founders – Ordinarily, the note holders will only seek minimal rights to the business (for example, information rights). As the investors will only become a shareholder later down the line, the founders will be spared from granting shareholder rights to the investors until the conversion. This makes business decisions easier.
• Convertible loan notes avoid placing a valuation on the start-up – This is particularly beneficial for seedling companies with limited operating history.  

What are the problems with convertible loan notes?

Although convertible loan notes can be a great way for start-ups to raise some cash, they aren’t without risks.

Some problems with convertible loan notes include:

• Bankruptcy – If the trigger event never occurs, the note will remain a debt. If the investors wish to redeem the debt, a company may go bankrupt trying to pay it off.
• Lengthy terms and conditions – If investors set stringent terms and conditions, they can take up as much time and effort as a traditional loan.
• Poor future investment prospects – If current investors receive significant discounts on their shares, this can affect the company valuation in future. This may mean that new investors will not want to pay more than the current investors, leading to problems.

Is a convertible loan note right for you?

If you’re a start-up looking for investment, there are lots of options to choose from. Whether you choose to go down a more traditional route or opt for a convertible loan note – both can be beneficial if done correctly.

You may be left wondering whether a convertible loan note is right for you? If so, why not chat with our friendly team. They’d be happy to advise on the best funding options for you and your business.