What is a convertible loan note?
A convertible loan note, also known as a convertible bond or convertible debt, is a type of debt financing agreement often used by early stage start-ups to raise funds. It is a cash loan that can be converted into equity (ownership in the company via shares) at a future date. Convertible loan notes are instruments for raising relatively small (yet crucial) amounts of cash between other rounds of investment.
Typically, convertible loan notes are issued between the bootstrap stage and the main funding rounds when shares are directly sold to investors (equity rounds).
Convertible loan notes are a convenient way to raise finance in the early stages of a company because issuing them does not require the company to be valued. An early stage start-up has little on which to base a valuation. But it can use convertible loan notes to attract investors willing to take the risk of injecting early cash with the hope of future gains when the company is valued and further equity is issued.
Conversion of the loan into equity (shares) is usually triggered by a future event, which might be:
- The note reaching maturity after an agreed period such as two or three years
- A subsequent funding round starting or reaching a certain threshold
- The company reaching a certain milestone in its growth plans
- The investor choosing to convert (the terms usually allow the investor to convert at their discretion)
- The company being acquired
- A longstop date being reached at which conversion takes place if a specified event has not happened in the interim.
Convertible loan notes are a convenient way to raise finance in the early stages of a company because issuing them does not require the company to be valued.
If no conversion occurs then the company will need to repay the loan with interest when it matures. It will also need repaying upon certain agreed events such as insolvency and material breaches of contract. But once the loan has been converted into equity, no further payment is required.
The investor is rewarded with any combination of three significant ‘perks’ for the risk they undertake in investing in the fledgling company:
1. Interest
The company makes interest payments, also known as ‘coupon payments’, into the investor’s loan account until the conversion into shares occurs. At that point the loan and its accrued interest are converted into equity. Interest on convertible loan notes typically ranges from 2% to 8% per annum.
2. Discount
The shares are often purchased at a discount compared to what is offered to new investors. A typical discount would be in the 10 to 30% range. However, 0% notes are not uncommon and are still attractive investments for other reasons such as interest and the valuation cap – see below.
The investor is rewarded with any combination of three significant ‘perks’ for the risk they undertake in investing in the fledgling company.
3. Valuation cap
A further and potentially significant ‘sweetener’ for the early investor in convertible loan notes – in fact something investors tend to insist on – is the valuation cap. A valuation cap fixes a maximum share value for the future conversion of the debt into equity. The investor will not pay more per share than this agreed amount. This protects the convertible loan note investor from seeing their stake diluted by subsequent share issues if the company performs well. They can potentially acquire shares for much less than second-round investors who buy straight equity. This can maintain or increase their percentage stake in the company when further shares are sold.
Valuation caps and the other ‘perks’ of convertible loan notes can make it harder to attract equity investment later, if equity investors feel the convertible debt holders are getting a significantly better deal. It can limit flexibility in setting the price for the next round of share funding. However, investors often insist on them, so early-stage financing often involves the delicate balancing of these competing concerns.
A convertible loan note does not have to feature all three of the above benefits. It can be interest only, discount only, or any combination of interest, discount and valuation cap. The terms are fully negotiable and will form the convertible loan agreement between both parties.
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Convertible loan note example
An investor buys £75,000 of convertible notes that carry 6% interest per annum and a 20% conversion discount. 2 years later an equity financing round sees the company sell shares to new equity investors at £4.50 per share. At this point the convertible loan note investor seizes the opportunity and converts their loan to shares. Alternatively, it may be that the financing round triggers the conversion automatically if that was previously agreed.
Their loan will have accrued £9,000 interest over the two years, assuming the agreement is for simple interest rather than compound interest, which is usually the case. Our investor will get new shares at £3.60 instead of £4.50, the agreed discount of 20%. They therefore receive 23,333 shares versus the 18,666 they would have received had they waited until now to purchase straightforward equity. This places the early investor at an advantage over the later investor, and this is their reward for taking the risk of investing early.
Like any financial instrument, there are both advantages and disadvantages to using convertible loan notes. Start-ups should work with their legal and financial advisors to determine whether they are the right financing option for their specific situation. Below we lay out the main pros and cons of convertible loan notes.
Advantages of convertible loan notes
1. Simplicity
Convertible loan notes are generally simpler and faster to negotiate and execute compared to equity financing rounds. The documentation is less complex and often cheaper to arrange. This can be beneficial for start-ups that need to raise funds quickly.
2. Delayed Valuation
Convertible loan notes can delay the valuation of a company until a later point, such as a future funding round or exit event. This can be helpful for start-ups that are still early stage and may not have a clear valuation yet.
3. Lower Interest Rates
Convertible loan notes typically have lower interest rates compared to traditional debt financing, which can make them a more attractive option for start-ups because they reduce the cost of borrowing.
4. Flexibility
Convertible loan notes can be structured in a way that provides flexibility for both start-ups and investors. For example, they can include terms such as conversion discounts, valuation caps, and interest rate adjustments.
5. Repeatability
Multiple convertible loan notes can be issued to investors under the same governing agreement. This can save time, legal fees and administration costs.
6. Independence
Until conversion, the noteholders are not members of the company and have no voting rights. This means they cannot directly influence the running of the company. In other words, the founders keep control of their company for longer than if they sold straight equity.
7. Ranking in liquidation
As creditors the investors’ unconverted debt takes priority for repayment in the event of liquidation. This can be seen as reducing initial risk. There is a set procedure for investors to recover their loans in insolvency – Creditors’ Voluntary Liquidation (CVL).
Convertible loan notes are generally simpler and faster to negotiate and execute compared to equity financing rounds. The documentation is less complex and often cheaper to arrange. This can be beneficial for start-ups that need to raise funds quickly.
Disadvantages of convertible loan notes
1. Dilution
Convertible loan notes can lead to dilution of existing shareholders’ equity when the notes convert. This can be a disadvantage for start-ups that want to maintain control over their company.
2. Uncertainty
These delayed finance instruments can create uncertainty for both start-ups and investors, as the ultimate conversion price is typically unknown until a future event occurs. This can lead to the value of a convertible loan note ‘ballooning’ in the event of a spike in performance and a high company valuation. If this happens an early investor might become disproportionately powerful.
3. Risk
These loans are a form of debt, which means that they come with risks for both start-ups and investors. For example, if the start-up fails to meet its obligations under the loan, the investor may have the right to take legal action. The terms may contain redemption provisions: events upon which the investor can call in their loan instead of converting it into shares. The company may struggle to repay the loan under these conditions. There can be many other risk factors depending on the specifics of each situation.
4. Complex Terms
The documentation can include complex terms and conditions normally used in stock markets. These may be difficult for start-ups and investors to understand. It’s important to have legal counsel review the terms and make sure that both parties fully understand them before entering into an agreement. Companies should also beware of getting too bogged down in defining the terms to cover every eventuality and satisfy investors, which wastes time and money and defeats the convertible loan notes’ purpose as vehicles for quick cash injections.
5. Lack of tax breaks
Compared with equity, convertible loan notes generally have less favourable tax treatment for investors. For example, there is no EIS/SEIS (Enterprise Investment Scheme/Seed Enterprise Investment Scheme) tax relief. This is because EIS/SEIS can only be claimed when fully paid shares are purchased – it does not apply to future convertibles. Profits from the shares may also be taxed on the investor as deep discounted bonds if they carry a high interest rate and/or redemption premium.
6. Accounting and tax complexity
Factors such as valuation caps, inherent risk and uncertainty, tax rules and specific details in the conditions of convertible loan notes can make them a headache for accountants.
Convertible loan notes can lead to dilution of existing shareholders’ equity when the notes convert. This can be a disadvantage for start-ups that want to maintain control over their company.
How should a convertible loan note be recorded?
The starting point of accounting for most convertible loan notes is to list them on the balance sheet as long-term liabilities. Most convertible loan notes are for a term of more than 12 months, which extends their scope beyond the current accounting period and makes them ‘long term’. They are a hybrid instrument consisting of a debt component and an equity component, and the equity component also needs accounting for in some way before conversion takes place. This area can be challenging to account for. Professional accounting assistance is highly advisable throughout.
Convertible loan notes should be listed on the company’s cap table as the amount of the loan with accrued interest and the maximum number of shares it is likely to convert into.
Whatever happens on the cap table and balance sheet, the register of members should only be changed when the shares have actually been converted and issued, at which point the investor becomes a shareholder.
Convertible loan note resources
Templates for a written resolution and board minute to issue a convertible loan note. Free to download and modify for your needs.
Downloads posted in: Share allotment resources
Steps to setting up a convertible loan note
- Check the articles of association for any restrictions that might affect the ability to issue convertible loan notes. The ability to create different share classes may be important here – see below.
- If applicable, verify that existing shareholders are content to waive their pre-emption rights over any newly-issued shares. This requires a special resolution of shareholders. Here is a free template for this special resolution which is also available in Inform Direct’s template library.
- Pass a board resolution to raise funds by issuing convertible loan notes. Keep the minutes – there is a template board minute for you to fill in in the downloads panel on this page.
- Determine the terms of the loan. This includes the amount of the loan, the interest rate, the repayment terms, and the conversion terms. The conversion terms will specify the conditions under which the loan can be converted into equity. Most convertible loan notes are unsecured but there may be security arrangements to agree on.
- Consider setting up a separate share class for the purposes of the convertible loan note. The particulars of the share class can be negotiated with the investor. The aim would be to find a balance of voting rights and dividends that represents added value for the investor but does not give them excessive power.
- Draft the loan agreement. The loan agreement should be drafted by a solicitor who is experienced in convertible loan notes. The agreement should include all the terms of the loan, as well as the conversion terms and any other relevant provisions.
- Agree on the terms with the investor. Once the loan agreement has been drafted, it should be shared with the investor for their review. The investor may suggest changes to the terms, and these should be negotiated until both parties are satisfied.
- Complete the documentation. Once the terms have been agreed upon, the loan agreement should be signed by both parties.
- Ensure compliance with legal requirements. There may be other legal requirements that need to be met, such as ensuring that the loan does not breach any securities laws.
Conclusion
Convertible loan notes can be a useful method of raising funds for early stage start-up companies and a profitable undertaking for investors. But they should be carefully negotiated to ensure that both parties are getting a fair deal. The whole arrangement is a finely balanced exercise in risk management based on the dynamic interplay between the competing interests of different parties: Convertible loan note investors, the company’s directors and shareholders, and later equity investors. Awkward and unforeseen situations can arise.
Eventualities such as insolvency should be planned for. It can happen, for example, that a company is unable to repay the loan when it matures and has not been converted into shares. The investor would then be entitled to foreclose on the loan – but this would drive the company into insolvency and render their investment worthless. Planning for such scenarios can give both parties a graceful exit strategy, or at least provide a framework for negotiating a resolution.
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