Convertible loan notes: how they work for start-ups

A convertible loan note is a loan to a company that the lender expects to turn into shares rather than be repaid in cash. The company issues the note, the investor pays in cash, and the agreement says when and at what price the balance converts. Start-ups often call it a convertible loan agreement; the terms are the same idea.

It is popular for seed and bridging rounds because it puts off the hardest question, what the company is worth. The founders and investors agree the conversion terms now and let the next priced round set the valuation. Until it converts, the note is debt on the company's balance sheet.

If you are weighing the main early-stage options, our guides to SEIS and EIS and angel investment cover selling shares directly. In brief, SEIS and EIS give investors income tax relief for buying new shares in qualifying companies, and that changes which instrument investors prefer.

The British Business Bank's Future Fund, which made convertible loans of £125,000 to £5m to start-ups, matched at least equally by private investors, from 2020 until it closed to applications on 31 January 2021, shows how these terms work in a real agreement. Its loans convert on a qualified financing round, carry a discount rate, an interest rate and in some cases a valuation cap, and if the company reaches the maturity date without converting, the Future Fund can redeem the loan with a redemption premium.

Suppose an investor lends £100,000 on a convertible loan note with 8% simple interest a year, a 20% discount and a valuation cap of £2m. The company has 1,000,000 shares in issue. Twelve months later it raises a priced round at a £4m pre-money valuation, so new investors pay £4.00 a share.

1. Amount to convert: £100,000 plus £8,000 interest = £108,000.
2. Discount price: £4.00 less 20% = £3.20 a share, giving 33,750 shares.
3. Cap price: £2m cap divided by 1,000,000 shares = £2.00 a share, giving 54,000 shares.
4. The note converts at whichever price gives the investor more shares, here the cap price: 54,000 shares.

The example shows why the cap matters most when the company does well. Without a cap, the investor's 20% discount buys 33,750 shares; with the cap, the same money buys 54,000. Founders should model conversions at several round prices before agreeing a cap. Our guide to how to value a business explains the methods investors use.

• Qualified financing. A priced equity round above a set size converts the notes automatically.
• Non-qualified financing. A smaller round may convert the notes only if the noteholders choose.
• Exit. A sale or listing before conversion triggers the exit terms.
• Maturity. If nothing else has happened by the maturity date, the agreement decides: repay the loan, convert at a fixed valuation, or extend.
• Default. Breaching the agreement can let noteholders demand repayment.

Maturity is where a note can bite. The Future Fund's guidance shows the choices in practice: at maturity it can redeem its loan, with the principal and a redemption premium, or accept conversion, and any extension needs the consent of the lenders under the agreement. A start-up that cannot repay at maturity is in a weak position, so agree conversion at maturity rather than repayment where you can.

No. Under section 173 of the Income Tax Act 2007, shares must be subscribed for wholly in cash and fully paid up when issued to qualify for EIS, and section 257CA sets the same requirement for SEIS. Shares issued by converting a loan are issued in exchange for the debt, not for new cash. HMRC's Venture Capital Schemes Manual also says an agreement used as a means of converting a debt into shares will not be considered eligible.

That is why UK start-ups seeking SEIS or EIS investors often use an advance subscription agreement (ASA) instead. HMRC says it will not consider an ASA suitable unless it:

• does not permit the subscription payment to be refunded under any circumstances;
• cannot be varied, cancelled or assigned;
• bears no interest charge; and
• has a longstop date by when the shares must be issued.

HMRC generally expects the longstop date to be no more than 6 months from the date the ASA is signed, and says a longer period makes advance assurance unlikely. The payment must not in effect be a loan. Take advice from an accountant before choosing between a note and an ASA, because the wrong choice can cost investors their relief. If you plan to seek advance assurance from HMRC, apply before the agreement is signed, and keep the terms of any ASA exactly as HMRC describes.

For a company with revenue that would rather not give up equity, venture debt or crowdfunding may be worth comparing.

Capzy is a credit broker, paid by the lender. We do not arrange convertible loan notes or equity investment, and we do not give legal, tax or investment advice. If your business is trading and wants debt finance instead, our guides to start-up business loans and other types of finance explain the options, and you can check your eligibility with a soft search that does not affect your credit score. Any offer is subject to status and lender criteria.