A convertible loan note can be a good way to raise money quickly for your company, without having to worry immediately about valuation of the company, and dilution of your shares.
Here’s how it works.
What is a convertible loan note?
A convertible loan note is a loan which is convertible on an exit event into the company’s shares. Conversion of the loan into shares occurring at a specified discount to the exit price. If the discount is at, say 20%, a loan of £800,000 will be convertible into a number of shares worth £1,000,000.
Why is agreeing a valuation not an immediate worry for a convertible loan note?
The company is valued at a point in the future when the equity round occurs or the company is sold, which are usually when the company has achieved certain corporate targets.
On an equity round, the discount is applied to the price paid for the shares by the equity investor. In other cases, the discount is applied to the share price is calculated from an independent valuation of the company.
Can a convertible loan note avoid dilution?
A convertible loan note allows founders to hold off agreeing the valuation until the company is in a stronger position. This means that founders can avoid giving away too much equity at an early stage.
What are the advantages of a convertible loan note to an investor?
A convertible loan note is a hybrid of loan and equity, which means that it has the following advantages to an investor:
- if the company does well, an investor can participate in the increase in value of the company; and
- if the company gets into financial difficulties, the amount invested becomes repayable.
What happens to the convertible loan note on an equity round?
On an equity round, typically, the convertible loan note converts into shares:
- automatically on a ‘qualifying equity round’, which is usually defined as an equity round above a specified threshold; and
- at the choice of each investor on a ‘non-qualifying equity round’, which is usually defined as an equity round below the specified threshold.
What happens to the convertible loan note on a sale of the company?
On a sale of the company, an investor in a convertible loan note can usually require either:
- conversion of the loan into shares, so that those shares can be sold using the ‘tag-along’ provision in the articles of association of the company; or
- repayment of the loan.
Will the convertible loan note need to be repaid?
The loan is typically repayable in 2 years. At that point, each investor in a convertible loan note can require the company to either:
- issue shares; or
- repay the loan.
What happens if the company does not have enough money to repay the convertible loan note?
Investors requiring repayment of the convertible loan note can cause difficulty for the company. If the company cannot pay but it is continuing to progress its business, the investors may permit extension of the repayment date.
Is interest payable on a convertible loan note?
The convertible loan note will incur interest, usually at a fixed interest rate. The interest amount might be ‘capitalised’, meaning that the interest amount is added to the overall amount of the loan. That overall amount then being either converted into shares or repaid at the end of the term of the convertible loan note.
Do investors in a convertible loan note have voting rights?
Until conversion occurs, investors in a convertible loan note won’t have any voting rights and so won’t usually have any influence over the company’s operations.
Will a convertible loan note affect future funding?
Care needs to be taken to make sure the convertible loan note will not put off future equity investors. Principal points to note are:
- an investor in a convertible loan note on conversion are likely to get similar rights to future equity investors but will pay less for the shares; and
- future equity investors may be deterred from investing where a significant proportion of the shares will be held by investors in a convertible loan note.
SEIS and EIS eligibility?
If the proposed investors are UK resident individuals, they often want investments to be eligible for tax relief under the EIS or SEIS schemes. You should note that a convertible loan note is not eligible for tax relief under the EIS or SEIS schemes.
What documents are needed to issue a convertible loan note?
It’s usually less hassle to offer a convertible loan note in comparison to shares. The documents required to issue a convertible loan note are:
- note certificate which describes the investor’s rights against the company;
- board minutes which evidence authorisation to issue the convertible loan note;
- written resolution which disapplies pre-emption rights, and if necessary, authorises the board to issue the convertible loan note; and
- consent under any shareholders’ agreement.
These documents are also usually easier to prepare and to negotiate than the documents required to obtain equity funding.
Convertible loan note, what next?
We help businesses of all sizes throughout the UK with convertible loan notes and other forms of funding.
To help your business set up a convertible loan note, get in touch.