A Convertible Loan Note is a debt instrument which converts to equity (i.e. shares) at a particular point in time. Seed investors often use them when they are investing in a startup and want to delay finalising a valuation for the business until a later funding round or some other milestone. The Convertible Loan Note documentation is relatively simple so they are often sold to friends, family and angel investors who support the founders. Convertible notes may have additional features, including valuation caps and/or discounts, to compensate the investor for the additional risks they are exposed to by investing in an early funding round. As it is a debt instrument, a Convertible Loan Note would typically accrue interest during its term (for the non-interest bearing equivalent instrument please see What is a SAFE?.
How does it work and why should I use one?
Compared to the more traditional route of a priced equity funding round, a Convertible Loan Note can be negotiated relatively quickly at minimal expense. This is mostly due to the deferral of the big question that would otherwise take up significant negotiating time: what is the value of the startup?
The three key terms of the Convertible Loan Note are:
• Valuation cap: The cap represents the maximum value at which the Convertible Loan Note may convert into shares in the next funding round, irrespective of the value which is agreed between the company and the new equity investors in that funding round. Founders should pay attention to what threshold amount of funds must be raised before triggering a conversion (see “Qualified financing” below), and the valuation cap amount: these two changeable numbers affect investors’ ownership of the company following conversion of the Convertible Loan Note into shares (i.e. the amount of dilution of the founders’ ownership).
• Conversion discount: The discount set out in the Convertible Loan Note allows an investor to convert the principal amount of their loan (plus any accrued interest) into shares at a discount to the purchase price paid by the new equity investors in the next funding round. If no funding round occurs prior to the “maturity date” (see below), then investors sometimes also have the option to convert at the valuation cap.
• Qualified Financing: Investors won’t want to convert their debt instrument and become shareholders at a time when the company does not have sufficient capital. So most Convertible Loan Notes specify a minimum amount of cash to be raised, above which an automatic conversion can occur. This is known as a “Qualified Financing”. Setting the threshold for a Qualified Financing is a balancing act: too low and investors may be nervous that a manufactured/sham financing could force the Convertible Loan Notes to convert on unfavourable terms; too high and the Convertible Loan Notes may not convert during a bona fide equity funding round. The automatic conversion will usually be at a discount to the price for the Qualified Financing equity funding round (or the valuation cap, whichever is more advantageous to the investor). The conversion is automatic because neither the company nor the investors vote on it.
Convertible notes will also include the following terms and features:
• Principal amount: The amount invested by the investor for the Convertible Loan Note.
• Maturity date: The date on which the company must repay the debt to the investor.
• Interest rate: The rate of interest which accrues on the Convertible Loan Note until it is converted into shares. Some Convertible Loan Notes provide that any accrued interest will be repaid to the investor upon a conversion event, while others will convert the accrued interest into additional shares on the same terms as the conversion of the principal amount.
• Conversion events and repayment terms: What are the events that will trigger a conversion (commonly referred to as “conversion events”)? What type of shares will the Convertible Loan Notes convert into (e.g. ordinary shares or preferred shares)? Can the maturity date be extended?
• Amendment: How can the terms of the Convertible Loan Note be changed? We typically see a clause setting out that holders of a majority of the principal amount of all outstanding Convertible Loan Notes may agree amended terms which will be binding on all Convertible Loan Notes. This is important because it gives founders the ability to handle renegotiations with investors and not be held to ransom by one wayward investor.
• Control and dividends: An investor does not usually have any management rights or receive any dividends until the Convertible Loan Note converts into shares.
Why would I not want to use a Convertible Loan Note?
The disadvantages commonly associated with Convertible Loan Notes are:
• Confusion over valuation: As we’ve already mentioned, using a Convertible Loan Note means the valuation question is deferred. This is an advantage in terms of speed and cost during the early stages of the business but delaying the valuation can lead to uncertainty over the percentage ownership investors will have following conversion of the Convertible Loan Note into shares. If the terms of the Convertible Loan Note will include a valuation cap, you may end up discussing value with investors regardless.
• Confusion over governance rights: Convertible Loan Notes largely avoid the issue of what rights the investors would have once they become shareholders upon a conversion (e.g. reserved matters, tag-along rights and drag-along rights etc.). Founders should keep this in mind and start the discussion with the noteholders when a conversion is on the horizon.
• Repayment at an inconvenient time: An investor may demand repayment of its investment if the maturity date is reached before a conversion event has occurred. The company may not have sufficient capital available to make the repayment. Founders may be able to negotiate an extension to the maturity date if, for example, a conversion event is approaching.
• Accounting treatment: A Convertible Loan Note is a debt instrument so will feature on the company’s books as a debt. This may not be attractive to banks and other third parties.
• Size: If the Convertible Loan Note is too large, it may have a negative impact on the startup’s next funding round: on conversion, it will result in the Convertible Loan Noteholders holding a disproportionally large portion of that round. Potential investors in the funding round may feel shut out from the equity stake they were seeking.
Why would I use a Convertible Loan Note instead of issuing shares?
There are several benefits in using a Convertible Loan Note:
• Speed: A Convertible Loan Note involves one document and you defer the valuation process and discussions to a later date. If you have less sophisticated initial investors, they will most probably find the Convertible Loan Notes documents more straightforward and can review them faster.
• Cost: It is cheaper to do a Convertible Loan Note than a round of equity funding for your company. Each dollar counts when you are still in the development, pre-product or pre-revenue phase, you will be particularly sensitive to costs.
• Show some love for initial investors: The variable share price in the Convertible Loan Note accounts for some of the uncertainty associated with investment in a startup. Founders may not appreciate this variable but it gives some benefit to initial investors for taking the plunge and making their early investment in your business.
• Stand-alone document: Unlike shares, a Convertible Loan Note does not come with director appointment rights or control provisions. All the terms attaching to share ownership are deferred to the subsequent equity funding round where they will be negotiated and finalised with the lead investor.
What is market?
We typically see conversion discounts ranging from 10% to 25%. Interest rates usually range from 5% to 10%. In our recent experience, the amount of cash raised to trigger a Qualified Financing is between 0.5 times and 2 times / 0.5x – 2x the principal amount of Convertible Loan Notes outstanding.
What else could I use?
Click here to generate your ScaleUp Convertible Loan Note.