Convertible loan notes (also known as CLN’s) are a type of debt funding that companies can utilise to raise money quickly. Companies can use them at various stages during the life of a company, however they are commonly used as a way of raising money in the early development stages.

What is a convertible loan note?

A convertible loan note is a loan that is repayable and bears interest. However, unlike other loans, in certain circumstances the loan can convert into shares in the borrowing company. A convertible loan note is a short-term debt which allows for a quick injection of cash into a company.

A company may decide to use a convertible loan note as they can have lower interest rates than other loans. Furthermore, in comparison to a normal equity investment they are easier to negotiate due to there being less documentation.

Conversion or redemption?

As mentioned above, a convertible loan note is repayable by the borrowing company, however in certain circumstances it will convert into equity. The typical events that will trigger a conversion are a successful round of funding or if the company is sold. It is common for convertible loan notes to be issued before a funding round so they convert into shares once the company obtains new investors.

Conversions will be triggered usually on a ‘qualifying’ funding round. A qualifying funding round will be an investment that exceeds an agreed amount before an agreed date. The specific terms of a qualifying funding round will be set out in an agreement. A qualifying funding round will trigger conversion of the loan notes into shares in the company. An advantage of a convertible loan note is that on a qualifying funding round the notes will usually convert into the most senior class of shares issued in the round at a discount to the price per share. The most senior class of shares will normally be preferred shares with preferential rights on liquidation and sale of the company.

If the company does not complete an investment round at the amount agreed before the agreed date, then this is commonly known as a ‘non-qualifying’ funding round. At this stage, the loan note holder will have the choice to convert the shares under the convertible loan note at a discount, redeem the loan or wait until a qualifying funding round in the future.

When a convertible loan note is redeemed instead of converted, the loan note will become repayable. The loan noteholder will usually be able to redeem the convertible loan note if there is not a qualifying investment round by a certain date, on a non-qualifying round or if the company becomes insolvent. Once repayment of the loan has been made, the loan will not be able to be converted into equity.

Advantages of using convertible loan notes

The main advantage of a convertible loan note is that it allows a company to raise money quickly and efficiently. As there is less documentation to draft and negotiate than a full equity investment, a company can keep costs down whilst trying to raise money.

Furthermore, before an equity round a company and its investors will need to negotiate the valuation of the company. By using convertible loan notes a company can delay the valuation negotiation. This can be advantageous to the company as they can delay the valuation until the company is in a healthier position. It allows time for the share price to increase and therefore can help a company avoid giving away too much equity at a lower share price.

For a noteholder, convertible loan notes can put them in a great position. As the loan can be repayable if the company is unable to complete a qualifying funding round then the company may have to pay the loan back to the noteholder. In the unfortunate event that a company becomes insolvent, a noteholder will have priority over shareholders when it comes to splitting the assets of the company. This means that convertible loan notes can be a safer way to invest. However, if a company grows successfully and receives an equity investment then the loan noteholder will benefit from a discounted rate when converting its existing loan into shares in the company.

Disadvantages of using convertible loan notes

When considering whether to issue convertible loan notes, a company should consider the impact they may have on future equity investors. If a noteholder is entitled to a large discount on shares it may put off future equity investors who will not receive this same benefit. If a funding round is made up of a lot of loan notes instead of money being raised, new investors could, again, find this unappealing.

If a noteholder is receiving a large discount on the shares under the convertible loan note agreement, then this may have a negative impact on the valuation of a company. Future investors may not wish to pay a much higher price than the discounted price that the noteholder benefited from.

A disadvantage for noteholders is that they may not be able to benefit from tax reliefs in the UK that they would be able to benefit from if they were equity investors. For example, the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) will not apply, so noteholders would miss out on potential income tax relief.

It is important for a company to consider whether convertible loan notes are a suitable way to raise money and at what time it would be best to issue the notes to allow the company to benefit from them.