A Guide to Convertible Loan Notes
What are they?
Convertible Loan Notes (“CLN”) are loan notes which grant the holder a right to subscribe or convert the loan amount into shares in the relevant company. We will explore the potential benefits and drawbacks of using CLNs in more detail below, but they are often used as a form of bridging facility by start-up companies ahead of a future round of venture capital financing.
Where an investor invests in a company via a CLN, unlike a venture capital investment where equity is issued up-front, the investment amount will be treated as a loan to the company and (subject to the terms of the CLN) there will be an option or right to convert that amount into shares in the company at a later point in time. Another key difference when investing via a CLN as opposed to venture capital, is that the share price and most likely the class of share will not be known at the date of the investment.
Convert into Equity or Repay the Loan
Typically, a CLN will provide two options for the company, either it can convert the investment amount (plus any interest) into shares in the company or it can repay the principal amount plus interest. The weight given to any pros and cons of each option might differ slightly between companies (due to differences in performance) but ultimately it comes down to the terms of the CLN.
Converting the CLN into Equity
Subject to the terms of the CLN, the loan may convert to shares in the company after a certain period of time has elapsed, on a set date or on the occurrence of certain conversion events. These conversion events may include, the start of a qualifying investment round (as will be defined in the CLN) or it might be in the event of a company sale. Providing the company performs well and manages to meet its financing targets, most noteholder investors will prefer for their investment to convert to equity as once they become shareholders they can share in the profit of the company and may have more control over how the business is to be run. However, the benefits of conversion and becoming a shareholder will depend entirely on the growth of the company and will also depend on the rights attaching to the shares into which the CLN converts.
The class of shares that the investment will convert into is typically at the discretion of the noteholder investor who is likely to want to subscribe for the highest class of share with the most rights attached. However, companies may request that the share class be selected on conversion or (less commonly) selected when the investor makes the initial investment.
Repayment of the Loan
Some, but not all CLN agreements will include rights for the noteholder investor to be repaid the amount of the loan (often plus interest, known as the coupon (see below)). These are referred to as rights of redemption (see further below). The terms of redemption will be specific to the CLN, but may include a redemption right where conversion hasn’t occurred by an agreed ‘longstop date’. This is the date by which the loan must convert to equity pursuant to the terms of the CLN and if those terms are not met, the principal loan amount will become repayable to the noteholder investors in full (plus any interest).
Redemption rights may also be triggered by reference to certain events, the occurrence of which mean the investment amount converts into a simple loan to be repaid by the company in full (plus the coupon) to the noteholder investor.
As with conversion into equity, a redemption of the loan ahead of conversion might be a better option for a noteholder investor where a company has failed to perform as predicted or where it has failed to meet its funding targets ahead of conversion. In this instance (where the terms of the CLN allow), the noteholder investor might elect for the principal amount (plus any interest which has accrued) to be repaid in full prior to conversion.
The coupon is essentially the amount of interest charged on the loan during the period up to the date it converts to equity. As with any normal loan, the terms of how this interest will accrue will be subject to the terms of the CLN. For example, it may accrue on a daily, monthly or yearly basis. Whereas, some CLNs provide for interest to be added to the amount of investment and therefore, on the amount to be converted into shares. It should be noted that not all CLNs provide for interest to be charged (although it is unlikely) and this will come down to the terms specific to that CLN.
As with any company selling equity, dilution of existing shareholdings will occur to account for the new influx of shares. This is an important issue that the founder / company needs to consider before issuing CLNs, as the exact amount of dilution will not be known until the qualified funding round occurs. The severity of the dilution hinges upon the terms relating to the interest rate, any discounts and existence of a valuation cap.
The Practical Requirements
The CLN agreement will need to include all key terms and will need to be signed and executed as a deed (Click here to download our template CLN with guidance notes as to how to properly draft the document). The length and complexity of CLNs can vary but the terms of the conversion or any redemption rights need to be agreed. As a result, parties often find that the time-consuming element of issuing CLNs is negotiating the terms of the CLN agreement.
The key terms of a CLN include:
- any discount applied to the shares or valuation cap;
- the conversion events and/or maturity dates;
- the amount of interest and how that interest will accrue;
- events of default; and
- the terms of any security.
We go into more detail about each of these terms below.
Discount vs Valuation Cap
One of the main benefits for a noteholder investor of using a CLN is that the price of equity on conversion will be lower than if they invested through a venture capital funding round. This lower price is based on either a discount on the price of the shares a conversion or valuation cap.
If the terms of a CLN include a share price discount, this is usually around 15-25%. Noteholder investors benefit from this discount when their investment amount is converted to equity in the company. To demonstrate these discounts, let’s consider the following scenario:
Investor A enters into a CLN for an investment amount of £50,000 with a conversion discount rate of 20%. The next qualifying funding round occurs and the then market value share price is £1.00 per share. Investor A’s investment of £50,000 converts pursuant to the terms of the CLN and after the 20% discount rate is applied, Investor A will be entitled to subscribe for shares at £0.80 per share.
In the qualifying funding round, which sees Investor A’s investment under the CLN convert to equity, Investor B separately makes a standard equity investment of £50,000 for 50,000 shares.
Investor A’s decision to invest in a CLN in place of directly investing in equity once the company has grown means that, for the same price, Investor A has acquired 62,500 shares in comparison to Investor B’s 50,000 shares.
From a noteholder investor’s perspective, the discount rate is seen as compensation for investing in the company at its early stages. Whereas from the company’s perspective, one drawback is that it can reduce the amount raised from a qualifying funding round because a large proportion of the shares will be immediately converted from the investments made pursuant to the CLNs rather than it receiving new capital from new investments.
A valuation cap is a cap or ceiling on the conversion price that will be used to calculate the value of the shares on conversion of the investment amount into equity. This protects the noteholder investor from “missing out” should the company’s value spike after the CLN is agreed. If the company valuation exceeds the valuation cap under the CLN then the noteholder investor will typically receive equity at a value equal to the lower of the value of the cap, the value at the discounted price (if one has been agreed), or the price agreed for the qualifying investment round. This also ensures that the holder of the CLN is guaranteed a minimum number of shares, irrespective of whether the next funding round shows the share price to be above the valuation cap.
Attention and consideration from both parties will be needed when negotiating a valuation cap to ensure that the valuation cap has the capability of reconciling future problems relating to a valuation.
As noted above, where a CLN does not convert to equity pursuant to its terms then the noteholder investor will require the principal amount under the CLN (as a debt) to be repaid, known as redemption.
The terms of redemption will depend on the terms negotiated under the CLN, but CLNs will often include a longstop (as mentioned above) or maturity date on or before which the investment must convert to equity otherwise the noteholder investor can require repayment of the principal loan amount plus interest. A typical CLN will include a longstop date or maturity date 3-5 years from the signing of the CLN.
Other common triggers for redemption of a CLN include, occurrence of an event of default (see further below), election by the noteholder investor either as an absolute right or perhaps linked to whether the company has met defined targets or as a result of a material breach.
When negotiating the CLN, noteholder investors may also seek a redemption premium[HB1] , to further increase the profit of the investment if the loan is redeemed rather than converted to equity. A redemption premium is an amount added on to the principal loan amount (plus the interest) convertible to equity or payable to the noteholder investor. Redemption premiums are usually 1x the principal loan amount or more. The imposition of a high premium is usually due to the high risk associated with making an investment at the early stages of a company. This may occur when the company has underperformed in respect of valuations and/or the securing of further capital.
Due to the nature of a CLN as a debt instrument, companies that fail to make redemption payments when due, will likely see CLN holders become creditors (who rank above shareholders in the event of insolvency) with significantly higher interest rates and the potential power to have the company wound up. Also, depending on the risk of the investment, noteholder investors may also require security (see further below) against the loan from the outset if the risk is high.
Events of Default
An event of default is an event that will trigger a redemption of the principal amount under the CLN together with any interest payable. The most common events of default include:
- where there is a material reduction in value of the company or its assets;
- events of insolvency (or similar) of the company;
- where the company ceases to carry on its business; or
- where the company is or is likely to be unable to pay its dets.
As noted above, because a CLN is a type of debt instrument, if the company defaults on the CLN, the noteholder investor will become a creditor of the company. If the company becomes insolvent or is wound up then creditors take priority over shareholders in the order of repayment out of any remaining capital left in the company. This is sometimes seen as another benefit of using a CLN, but this is caveated by the fact that there will not always be enough capital available to repay all creditors in the event of insolvency. This is one of the reasons that noteholder investors may seek security for the loan where an investment is deemed high risk.
CLNs are commonly unsecured, the view being that they are prepayment for shares rather than a debt instrument. Founders of a company should always try to resist the insertion of any type of security provisions within a CLN. However, where an investment is viewed as high risk, a noteholder investor may seek security so that in the event of default, it can still recover the principal amount if the company is unable to repay it.
There are two ways to secure a CLN. The CLN may be secured by way of a fixed and floating charge in the form of a debenture or alternatively by way of a guarantee. If the CLN is being used as a form of short-term bridging facility ahead of a further round of financing then usually security will be by way of a debenture. However, some noteholder investors may require a guarantee either from a third company or from the directors of the company who will personally guarantee to repay the principal amount.
Guarantees are less common and companies should fully consider the implications of giving a guarantee in any form, particularly a personal guarantee where any default in this scenario could potentially give rise to personal bankruptcy if the guarantee is enforced and the individual is unable to pay the relevant amount.
- Noteholder investors benefit from the discount or valuation cap applied at the point of the conversion into equity so if the company has grown as predicted, the noteholder investor will benefit from a greater share of equity for less investment than if they had invested the same amount as part of a later venture capital funding round. Subject to the forecasted performance of the company, this is a huge benefit to a potential investor.
- A CLN is first and foremost an instrument of debt up to the point of conversion and (as explained above) the holder will rank higher than a shareholder’s equity stake in the event of insolvency. As a result, the investment poses less risk at a time that would usually amount to more (i.e. because identifying the value and prospects of the business may be difficult).
- If the company defaults on the loan and becomes a creditor, a CLN will rank higher than other unsecured creditors so if the company seeks to take on further debt, it may need the consent of the CLN holder(s). This provides even greater security for the noteholder investor.
- The noteholder investor will often be able to elect which class of shares the equity converts into meaning it can select the highest class of shares with the most rights attaching to those shares (for example as regards to dividends and voting rights). This will give the noteholder investor more control over the company once it becomes a shareholder.
To the Company/ Founders
- Faster and less complex way to raise early-stage financing (in turn this can mean they cost the company less) because, unlike venture capital funding rounds, there is usually limited due diligence, no need for complex valuations and no requirement for parties to negotiate documents such as amended articles of association and investment / subscription agreements.
- The founders can delay dilution of their shares until conversion (because CLNs offer minimal rights and noteholder investors will not obtain shareholder rights until conversion) allowing greater control over the company during its early growth stages and, subject to the redemption terms of the CLN, founders may be able to avoid dilution altogether by repaying the principal amount of the CLN plus interest before it crystallises into equity.
- The CLN is also made available to the company / founders without the necessity to define the value of the company up-front, which is normally in the interest of the company/ founder to delay valuation, so as to not give away large chunks of equity.
- The company/ founders are often able to dictate the terms of the CLN to place themselves in a favourable position, these terms will be the same for all lenders.
- The benefits relating to enterprise schemes (such as SEIS/EIS) do not apply to CLNs and noteholder investors will be unable to receive the large tax breaks and capital tax exemptions that arise from such schemes.
- It is often difficult to value a company and therefore its share capital at early stages meaning noteholder investors can find it hard to determine whether the terms of a CLN are fair or even worth it. In any event, some more risk-averse investors prefer to wait for venture capital rounds where the value of the shares they are subscribing for is known.
- As a CLN is debt instrument until conversion, the noteholder investor will not enjoy any of the typical rights that a shareholder of the company would enjoy (such as voting rights, dividends or rights to capital on a winding up) until after conversion when they become a shareholder. Also, it means that until conversion, the value of their investment will be impacted by future investors who are free to agree a company valuation without reference to the noteholder investors.
To the Company/ Founders
- On conversion (taking into account interest) noteholder investors may be able to subscribe for more equity than the company had intended or even considered when agreeing the CLN. This could have the effect of stifling the company’s ability to raise further capital, as the noteholder investor(s) would own a larger portion of the shares than first anticipated. As a worst-case scenario, it could result in noteholder investors becoming majority shareholders, as the existing shareholders are diluted.
- CLNs are debt instruments up until conversion, so if the company would not be in a position to repay the loan if the redemption provisions in the CLN agreement were triggered, then the consequence is that the noteholder investor will become a creditor of the company. As noted above, this places the noteholder investor (as a creditor) above founding shareholders in the event of insolvency. It also means that the company may need consent of the noteholder investor (where it becomes a creditor) to apply for any future debt financing.
- If noteholder investors are receiving a large discount on the price paid for shares on a qualifying funding round, then there is a risk of this affecting the valuation of the company in future rounds as future investors (if they become aware of the price of conversion under a CLN) will not want to pay a much higher price.
- Noteholder investors are often free to select the class of share that the investment will convert into and most noteholder investors will elect the highest class of shares because after conversion those shares will grant the holder more control and/or more income by way of dividend payments.
How can we help?
At the Jonathan Lea Network, we regularly support and advise start-ups with regard to early-stage investments. If you would like advice and assistance on the implications of offering CLNs to investors please send an email to firstname.lastname@example.org or complete this form to arrange a free 20-minute consultation.
Otherwise, we offer a convertible loan note template on our website shop amongst several other crucial templates (with respective guidance notes) to assist you in both the early and later stages of your business.