What are convertible loan notes?

Smaller businesses commonly use convertible loan notes to secure investment.

Read our guide to how this form of funding could benefit your business and the potential downsides to look out for.

Convertible loan notes (CLNs), also known as convertible debt notes and convertible debt, are a form of finance provided to businesses that give the investor the option of converting the debt into equity at a future date, often at a discounted rate compared to that offered to new investors.

CLNs are a popular way for early-stage, high-growth start-ups and small companies to raise funding because they allow them to access finance before a company valuation has been set.

What are convertible loan notes?

A CLN involves an investor providing debt funding to a business.

However, unlike other loans, which generally involve the business owner paying back the original funding with interest, CLNs include an agreement for the investor to convert the loan into equity shares in the business when certain events occur (often referred to as the ‘trigger event’), such as another funding round or an acquisition.

Common details included in a CLN agreement are:

• conversion trigger – the event that must occur before the CLN is converted into equity, such as a funding round or an initial public offering (IPO)
• equity discount – a discount for investors which means they can purchase equity shares at a lower rate than any future new investors
• maturity date – the point at which the note converts to equity, or the business owner must pay the principal loan amount and interest
• valuation cap – the maximum company valuation at which the CLN converts into equity, ensuring investors receive a more favourable conversion rate if the company valuation is higher
• interest – the interest payable by the business for the initial loan the investor provides, typically between 2% and 8%.

Where are convertible loan notes used?

Early-stage and high-growth businesses typically use loan notes as a bridge between funding rounds.

Entrepreneurs can struggle to calculate a valuation for their new business because they have limited information to base it on.

However, CLNs don’t require a valuation, so they can be used to secure investment at an early stage.

For investors, CLNs tend to be less risky than buying shares directly in new companies. 

What are the advantages of convertible loan notes?

The advantages of convertible loan notes include:

Simplicity and speed

CLNs’ terms are less complicated than those of other types of loans or equity funding, so they are usually quicker, cheaper, and easier to access, depending on the complexity of the terms negotiated.

CLNs can sometimes be arranged in days or weeks, compared to other equity finance, which can take many months.

Flexibility

The terms of a CLN can be structured to suit both the business and the investor.

Some CLNs do not require collateral like traditional bank loans, which makes it easier for start-ups to access them and less risky for investors.  

Lower initial valuation pressure

CLNs do not require a business valuation, which means start-ups can delay their valuation until later rounds of funding and avoid giving away too much equity at an early stage.

Lower interest rates

Depending on the negotiated terms and perceived risk, CLNs can often have lower interest rates than traditional loans.

What are the disadvantages of convertible loan notes?

The disadvantages of convertible loan notes include:

Risk of dilution

Once the loan matures and is converted to equity, the founders’ shares may be diluted, potentially reducing their control of the company, especially if the valuation at conversion is lower than anticipated.

Uncertainty

As the business valuation isn’t set when the convertible loan notes are issued, the potential return on investment is often unclear for the investor and entrepreneur.

Risk of financial difficulties

If the ‘trigger event’ does not occur, such as a subsequent funding round not being achieved, then the debt will need to be repaid.

This could be difficult for a poorly financed small business.

Potential impact on future financing rounds

Investors backing a business via a CLN might discourage future investors if the terms of the CLN, such as a valuation cap or discount, create a significant advantage for earlier investors, leading to potential dilution or less favourable terms for new investors.

Lack of tax relief eligibility

CLNs do not qualify for the tax relief provided by the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) unless specifically structured to meet the criteria, such as conversion, dependent on certain conditions.

This means business owners using CLNs miss out on being able to use the tax advantage to attract investment, and investors miss out on the tax relief. 

How can small businesses access convertible loans?

The steps for securing a convertible loan include:

Preparation

Like with any form of funding, preparation is crucial.

Before seeking an investor willing to provide a CLN, you need to ensure you fully understand this type of funding and know that it’s the correct form of finance for your business.

You need a clear understanding of your business, where it’s going, and what you want the money for.

Have a business plan to provide to potential investors.

A cash flow forecast is also useful.

Finding investors

There are various ways to find investors.

Speak to other business owners and ask for introductions to investors.

Attend business events where investors might be present.

Look for events on platforms like Eventbrite and Meetup and the websites of groups such as the UK Business Angels Association.

Search on professional network LinkedIn for investors.

Check who your LinkedIn connections are connected to – they might know investors they could introduce you to.

Negotiating terms

When negotiating the terms of a CLN, be clear about what you want to achieve, but be prepared to negotiate to complete a deal that is acceptable to both parties.

Strong communication with the potential investor is key to building trust.

Be open about your plans and ambitions, and address the investor’s feedback and concerns transparently and efficiently.

You may need to be flexible to get the funding you want. 

For example, you could offer a higher interest rate in return for a lower valuation cap.

When negotiating the maturity date, consider the time you need to secure a subsequent funding round.

You might want to ensure you have enough time to raise more funding but don’t have a maturity date that’s so far away it puts off future investors.

Legal considerations

Negotiating the terms of a CLN can be complicated, so it is recommended that you seek the advice of an accountant or solicitor.

Check that your company’s articles of association permit you to issue convertible loan notes. 

If not, you might need to create a new class of share.

You’ll likely need a solicitor’s help drafting the loan agreement, which should include terms such as the maturity date, valuation cap, interest, and equity discount.