A convertible loan note is a loan from an investor to a company that turns into shares later, usually when the company sells shares in a priced funding round. Until it converts, it’s debt. It sits on the balance sheet as a liability, it usually carries interest, and it has a date by which it has to be repaid or converted.
Convertible loan notes, also called CLNs or convertible notes, exist because early-stage companies are hard to value. A business with little revenue and no track record gives the founder and the investor very little to agree a price on. The note lets the money go in now and leaves the valuation to be set when a priced round puts a number on the business.
I’ve raised £250m+ for my own companies and funded more than 750 businesses with over £1bn, so I’ve seen raises as a founder, as an investor and as a lender.
What a Convertible Loan Note Is
The investor lends the company money under a written agreement, usually signed as a deed, that sets out when and how the loan turns into shares. The company keeps a register of who holds the notes. Several investors can lend on the same terms at the same time, so a group of notes issued together is often called a round, even though no shares have been issued yet.
The investor isn’t a shareholder while they hold a note. They have no vote and no right to dividends. What they have is a right to be repaid, and a right to receive shares when a conversion event happens. The note sets out those events, which include things like:
- a qualifying funding round, where the company sells shares at an agreed valuation and raises at least an amount set in the note
- a sale of the company or a listing on a stock market
- the maturity date, when the loan falls due if nothing else has happened first
The noteholder lent before anyone knew what the shares would cost, and the note rewards them for that with a discount, a valuation cap and interest.
Discount, Valuation Cap and Interest
| Term | What it does | Figure used in the example below |
|---|---|---|
| Discount | Converts the loan at a lower price per share than the new investors pay in the qualifying round | 20% |
| Valuation cap | Sets the highest valuation the loan can convert at, however high the round is priced | £4m |
| Interest | Adds to the amount that converts, usually rolled up rather than paid in cash | 8% a year, simple |
| Maturity date | The date the loan falls due if it hasn’t converted | 24 months |
| Qualifying round | The minimum amount of new money that triggers conversion | £1m |
The discount. If the new investors pay £6 a share and the note has a 20% discount, the noteholder converts at £4.80. They get more shares for each pound than the investors coming in later, because their money went in first.
The valuation cap. A discount on its own does little for an early investor if the business grows fast, because 20% off a high price is still a high price. The cap sets a maximum. A £4m cap means the loan converts at the price per share the company would have at a £4m valuation, whenever that’s lower than the discounted price. Where a note has both, the noteholder converts at whichever price is lower.
The cap is negotiated the same way a valuation is. The founder sets it and has to justify it, using the methods investors use for startup valuation, and the investor brings their own number.
The note also defines how the cap is measured, for example whether it’s a pre-money valuation and whether the share count includes the conversion shares and any option pool. The difference between pre-money and post-money valuation changes how many shares the note converts into, so it’s written into the note rather than left to be worked out at conversion.
Interest. Many notes roll the interest up, so nothing is paid in cash and the interest converts into shares along with the loan. Where interest is paid in cash and the note can run for more than a year, the company generally has to deduct income tax from interest paid to individual noteholders and pay it over to HMRC.
Conversion Worked Example
Say a company with 1,000,000 shares in issue raises £250,000 on a convertible loan note with a 20% discount, a £4m valuation cap and 8% simple interest a year. 18 months later it raises £1.5m from new investors at a £6m pre-money valuation, which is the value of the business before the new money goes in.
- The round price. £6m divided by 1,000,000 shares is £6.00 a share.
- The discounted price. £6.00 less 20% is £4.80.
- The cap price. £4m divided by 1,000,000 shares is £4.00.
- The conversion price. The lower of the two is £4.00.
- The amount converting. £250,000 plus 18 months of interest at 8% a year, which is £30,000, comes to £280,000.
- The noteholder’s shares. £280,000 divided by £4.00 is 70,000 shares.
The new investors get 250,000 shares for their £1.5m at £6.00 each, so there are 1,320,000 shares after the round.
| Shareholder | Shares | Holding | Value at £6.00 a share |
|---|---|---|---|
| Founders | 1,000,000 | 75.8% | £6,000,000 |
| Noteholder | 70,000 | 5.3% | £420,000 |
| New investors | 250,000 | 18.9% | £1,500,000 |
| Total | 1,320,000 | 100% | £7,920,000 |
The noteholder’s £280,000 has become shares worth £420,000 at the round price. The founders hold 75.8%, where they’d have held 80% if only the new investors’ shares had been issued, because the conversion shares are issued at the same time and dilute the existing shareholders too.
The round’s valuation decides whether the discount or the cap gives the lower price.
| Round pre-money valuation | Round price | Discounted price | Cap price | Conversion price | Noteholder’s shares | Value at round price |
|---|---|---|---|---|---|---|
| £3m | £3.00 | £2.40 | £4.00 | £2.40 | 116,667 | £350,000 |
| £5m | £5.00 | £4.00 | £4.00 | £4.00 | 70,000 | £350,000 |
| £6m | £6.00 | £4.80 | £4.00 | £4.00 | 70,000 | £420,000 |
| £8m | £8.00 | £6.40 | £4.00 | £4.00 | 70,000 | £560,000 |
Below a £5m round valuation the discount gives the lower price, and the noteholder’s shares are worth £350,000, the £280,000 grossed up by the 20% discount. Above £5m the cap applies, and the higher the round is priced, the more the noteholder’s shares are worth compared with the amount they lent.
Maturity: What Happens If There’s No Funding Round
If no qualifying round has happened by the maturity date, the note sets out what happens next. The options include things like:
- Repayment. The company repays the loan and the interest in cash.
- Conversion at a set valuation. The noteholders can choose to convert, often at the cap, into an existing class of shares.
- Extension. A set majority of the noteholders agree to move the maturity date.
Where the note gives the noteholders a right to repayment, the company owes the money in cash at maturity unless they choose to convert or agree to extend. Until then they’re creditors of the company. An unsecured note ranks alongside the company’s other unsecured creditors and behind any lender with security. A SAFE works differently. It has no repayment date and isn’t a loan.
A Sale Before Conversion
If the company is sold before the note converts, the note usually gives the noteholder a choice between repayment, sometimes of a multiple of the loan such as 2x, and converting into shares just before the sale, often at the cap. Converting means they take part in the sale proceeds as shareholders, which is worth more when the sale price is well above the cap.
Convertible Loan Notes and SEIS/EIS
Shares issued when a convertible loan note converts don’t qualify for SEIS or EIS relief. HMRC’s guidance on the requirement to raise money says issuing shares to repay a loan, including by converting loan stock, doesn’t raise money for the company. The SEIS rules also need the shares to be paid up in full, in cash, when they’re issued.
That means CLNs and SEIS or EIS relief don’t work together for an investor who wants the income tax relief. A UK company raising from those investors can issue ordinary shares at an agreed valuation, or use an advance subscription agreement, a UK structure where the investor pays now for shares issued later, which HMRC accepts for the reliefs when it meets HMRC’s conditions.
Issuing and Converting the Notes
- Agree the terms. The amount, the discount, the cap, the interest, the maturity date, what counts as a qualifying round and what happens on a sale. The investor pitch deck says how much is being raised and on what structure, and an investment memorandum, where there is one, sets out the terms in full.
- Get the approvals. The directors approve the issue. Because the notes will become shares, the company usually gets shareholder authority to allot those shares and has existing shareholders’ pre-emption rights waived or disapplied at the same time, so the conversion isn’t held up later.
- Sign the note and take the money. The company signs the note, records each holder in its register of noteholders and usually issues each of them a certificate. An unsecured loan needs no Companies House filing. A note secured with a charge has to be registered within 21 days.
- Due diligence. Before investing, the new investors in the qualifying round look at the business, the plan and the notes. They will then do their due diligence and check what they have been told is true, including how many shares the notes convert into and on what terms.
- Convert. On conversion the company issues the shares and files a return of allotment, form SH01, with Companies House within one month, with a statement of capital. The register of members and the cap table are updated to show the new holders.
When a Convertible Note Fits and When It Doesn’t
| Convertible loan note | SAFE | Priced equity round | |
|---|---|---|---|
| Debt or equity | Debt until it converts | Not debt: a right to shares later | Equity from day one |
| Valuation agreed now | No, a cap and a discount | No, usually a cap, a discount or both | Yes |
| Interest | Usually | No | No |
| Repayment date | Yes, the maturity date | No | No |
| SEIS/EIS in the UK | Conversion shares don’t qualify | A standard SAFE doesn’t meet HMRC’s conditions | Ordinary shares can qualify |
| Documents | The note and the approvals | A short standard agreement | Term sheet, subscription agreement, shareholders’ agreement and usually new articles |
A convertible note tends to fit when:
- the founder and the investor can’t agree a valuation yet and would rather leave it to a priced round
- the company is raising a smaller amount from a few investors ahead of a larger priced raise, where the legal work of a full round would be out of proportion to the money
- existing investors are putting in more money to get the business to a specific milestone, such as a product launch or a signed contract
It fits less well when:
- the investors want SEIS or EIS relief
- the company couldn’t repay the loan at maturity if no round happens and the noteholders don’t convert
- the amount is large enough that the investors expect a priced round, with the valuation and their rights set out in a term sheet
- the business has the revenue and assets a lender would lend against, and borrowing would leave the shareholding untouched. For UK businesses, Funding Guru arranges that kind of borrowing.
Whatever the structure, the amount comes from what the money is going to be used for and the plan, built up from its parts. It isn’t just a round number plucked out of the air.
Convertible Notes Outside the UK
A convertible note is a contract between the company and the investor, so the discount, cap and conversion terms work the same way whether the company is in the UK, the US, Australia, Singapore or the UAE. Local law decides how the note is taxed and who it can be offered to.
In the US, convertible notes have long been used for early rounds. Y Combinator created the SAFE in 2013, which does a similar job without being a loan, so it has no interest and no maturity date.
FAQs
Is a convertible loan note debt or equity?
A convertible loan note is debt until it converts. The investor is a creditor with a right to repayment at the maturity date, and only becomes a shareholder when the note converts into shares.
What is a valuation cap on a convertible note?
A valuation cap is the highest company valuation a convertible note can convert at. If the qualifying round is priced above the cap, the noteholder converts at the cap’s lower price per share and gets more shares than the discount alone would give.
What happens to a convertible loan note if the company doesn’t raise?
It falls due at the maturity date. Depending on the note, the company repays the loan and the interest, the noteholders convert at a set valuation, or a majority of noteholders agree to extend the date.
Do convertible loan notes qualify for SEIS or EIS?
No, shares issued by converting a convertible loan note don’t qualify. HMRC treats them as issued to repay a loan rather than to raise money, and SEIS and EIS shares have to be paid for in full, in cash, when they’re issued.
Do convertible notes pay interest?
Usually, yes, but the interest is often rolled up and converted into shares with the loan rather than paid in cash.
Next read
The discount, the cap and the maturity terms on a convertible note are agreed in a negotiation, and how to prepare for a negotiation like this and run it is what I teach in the Negotiation Masterclass. If you’re raising and want it run properly, from making the business investable to getting in front of the right investors, that’s what Capital Raiser does. If you’re earlier than that, join Capital Catalyst for free and learn how every type of funding works before you take any of it.
This explains how convertible loan notes generally work for UK companies. It isn’t legal, tax or investment advice, and a solicitor and accountant should review the note before it’s signed.
