When Should you use a Convertible Loan Note?

October 6, 2022

Convertible loan notes are useful for start-ups to generate an initial sum of money to advance their business, whilst trying to secure some direct equity investment. Consequently, convertible loan notes are a short-term solution to financing needs and once in place, can be an indication to future investors as to the potential of the business. 

What is a convertible loan note?

A convertible loan note is essentially a loan which bears interest and is repayable at some point in the future, except that they convert into equity in certain circumstances, usually a future equity round or sale of the company. It is essentially a loan that is never meant to be paid back and will ultimately convert into shares. 

Why use a convertible loan note?

There is less documentation to negotiate than in a normal equity round, so a convertible loan note can be put in place quickly and allows companies to minimise the costs of raising money when budgets are tight. 

What are the advantages of a convertible loan note?

A convertible loan note allows companies to raise money quickly, but it also allows the company and the loan note holder to delay negotiating the valuation of the company until the first equity round. If the company is not yet profitable (or has not started to trade) it can be very difficult to value the company. A convertible loan note can allow the Founders to hold off negotiating the value of the company until it is in a stronger position and avoids giving away too much equity at an early stage. 

What are the advantages of a convertible loan note to an Investor?

Convertible loan notes are often said to give the investor the best of both worlds. This is because on insolvency, debt is paid off before equity. This is a big attraction for investors. On the other hand, if the company eventually raised money by selling shares to later investors in an early stage financing round, then rather than pay back the outstanding amount, the loan note is converted into shares in the company, usually at a discount off the price offered to new investors. This means the investor enjoys the downside protection typically associated with debt but is also able to enjoy the upside opportunity typically enjoyed by equity holders. 

When do convertible loan notes convert?

A convertible loan will convert into shares according to the terms specified in the relevant document. This term is important for both parties. Investors will no doubt want the ability to convert their loan to equity in as many circumstances as possible, in order to ensure they get the most from their investment. However, from a founder's perspective, it is always best to try and limit the triggers for conversion to

  • (1) a full equity round investment at a decent level, and, on...
  • (2) a change of control of the company. 

When do the convertible loan notes get redeemed?

The convertible loan note will also include redemption provisions, which will allow the investor on certain events happening to redeem the loan instead of converting it into shares. This can cause difficulty for the company. How are they going to find the money to repay the investor? Or, if there is a clause for late payment, how are they going to find the money plus interest?

What are the disadvantages of a convertible loan note?

Start-ups should ensure that they do not enter terms in relation to the convertible loan notes that will put off future investors. Founders should always be careful about giving up too much too soon and founders should remember if there is interest from other investors, then there is no need to be pushed into accepting unreasonable terms.  

If your investors are seeking to benefit from Seed Enterprise Investment Scheme (SEIS) or Enterprise Investment Scheme (EIS) reliefs then a convertible loan note will not be suitable and they will need to look at an equity financing round instead. SEIS and EIS are very valuable tax reliefs for business angels in the UK and are the main reasons why convertible loan notes are not as widely used in the UK as they are in the U.S.

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