Convertible Loan Notes

10 September 2023

Convertible loans are a way for early stage companies to raise money from investors, usually ahead of a full funding round. Investors benefit by getting a discounted rate on their converted share price as a result of investing early in the company, whilst the company is able to secure investment without immediately giving away large amounts of equity.

What is a convertible loan note?

A convertible loan note (CLN) is the most common instrument used for agreeing convertible loans. The CLN is a short-term loan that is then converted into equity shares at a later date, generally in the event of a further funding round. Early stage companies can use CLNs to raise working capital as their company grows, as an alternative to a standard loan or equity investment.

Although the loan will normally be converted into equity, some CLN terms also allow for the loan to be repaid instead under certain conditions.

When is the loan converted into equity?

The company and the investor will agree at the outset the conditions upon which the loan will convert. Usually this will be on a qualifying funding round – the parties will set a minimum figure to be raised in order for the conversion to be triggered.

There is typically also an agreed upon period within which the qualifying funding must be raised – often 12-24 months after the investment. If the funding target is not reached by the end of this period, the debt can then either be redeemed or converted at a pre-agreed share price.

How is the share price agreed?

The final conversion price is not decided when the CLN is issued, although there may be a maximum share price stipulated in the CLN. Instead, price per share is determined at the point at which the conversion is triggered, usually at a funding round.

Delaying the valuation of the company until this funding round gives the share price time to increase as the company grows. This is useful to the company since it can reduce the amount of equity they are obliged to issue (and so minimise dilution for shareholders). The investor still benefits from a discounted share price compared to later investors.

Do Convertible Loan Notes accrue interest?

CLNs can accrue interest during the period leading up to their conversion. The interest rate is agreed between the parties. But it generally reflects the level of risk for the investor – which is considered high for early stage companies since they are unlikely to be profitable or have significant assets. 

Interest is either payable as it accrues or it can be added to the principal amount and either repaid or turned into shares upon conversion. 

Are they secured?

Some CLNs are secured against company assets to protect the investor’s interests. However, since  CLNs are generally seen as an advance payment for shares, rather than a loan, many are unsecured. Instead, the company promises to either pay back the loan or issue the amount of equity.

What are the benefits of a convertible loan for a company?

The benefits of a convertible loan for a company include:

  • A fast and inexpensive method of securing working capital until they can do a full funding round.
  • Interest payments can be deferred and offered as convertible equity, taking pressure off the company’s cash flow.
  • It is easier to find investors, since CLNs offer the investor more control and a better yield than a traditional debt.
  • In some cases the option for the loan to be redeemed, rather than converted, means that the current shareholders can avoid giving away equity if the company can find a way to repay the loan.

What are the benefits of a convertible loan for an investor?

The benefits of a convertible loan for an investor are:

  • A discounted share price when their loan is converted into equity, based on the market valuation at that time.
  • If the company doesn’t perform as well as expected, the loan can be redeemed rather than converted into equity, safeguarding the investment.
  • CLNs can include a valuation cap to decide the maximum share price that the loans can be converted for. This protects the investor in the situation where the company rapidly increases in value during the loan period.
  • In the event of insolvency, the investors are in a stronger position than if they held equity, since debt is ranked higher than equity in this situation.

The contents of this article do not constitute legal advice and are provided for general information purposes only.

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