In the UK, convertible loan notes have become a popular option for startups and early stage companies looking to raise finance. These are financial instruments that allow investors to lend money to a company in return for the option to convert that loan into equity at a later date.
When an investor buys a convertible loan note, they are, in essence, lending money to the business, but when certain conditions are met, that money can then be converted to equity or shares. Typically, this conversion occurs when the company satisfies certain conditions, such as a new funding round or an IPO (Initial Public Offering).
Pros of convertible loan notes
The main benefit for both investor and business is flexibility, as the terms of the convertible loan note can be structured in a way that is acceptable for both parties. As a result, the company is able to raise financing without immediately diluting the equity of existing shareholders, while the investor has the opportunity for equity ownership at an agreed point in the future. Let’s delve deeper into the advantages and disadvantages for a business:
Flexible terms – Businesses are able to negotiate favourable terms that take account of the company’s circumstances. These can include conversion discounts, valuation caps, interest rate adjustments and the maturity date.
Delayed equity dilution – This is another big advantage for the company as, instead of issuing equity immediately, the conversion to equity occurs at a later date, usually at an agreed milestone.
Attractive to investors – Typically, convertible loan notes offer a greater return to investors than traditional loans, mostly due to capital appreciation. For this reason, they can be more attractive. The use of a convertible loan can be seen as a signal to other investors that the business has potential, and, as a result, attract more investors.
Bridge financing – Convertible loan notes can serve as a source of “bridge” funding in advance of a larger equity investment round. This can be vital in keeping a business up-and-running until a more substantial funding is secured.
Unpredictable valuation – The conversion price of the loan depends on the valuation of the company at a later date. For obvious reasons, this can be difficult to discern and may lead to disagreements between investors and company owners. Disagreements can arise over other terms of the arrangement, so it’s important to create a contract that protects the business from a corporate firm of solicitors, such as JPP Law.
Equity dilution – While equity dilution does not occur in the short term, it is not eliminated entirely. Eventually the loan note will be converted to equity and dilution will occur. At this stage, owners can potentially lose some control over the business.
Complexity – The terms and conditions associated with convertible loan notes can be complex. For this reason alone, it’s essential to secure the services of a corporate lawyer with a successful track record in dealing with these sort of loans.
SEIS/EIS eligibility – Crucially, convertible loan notes are not eligible for tax relief under the Seed Enterprise Investment Scheme (SEIS) and the Enterprise Investment Scheme (EIS). Under these schemes, private investors can take advantage of tax relief offered for investing in early-stage, “high-risk” companies. These can be valuable tax breaks for UK investors, so not having this advantage may put off potential investors.
Are convertible loan notes right for your business?
Offering flexibility and attractive terms, convertible loan notes can be useful short-term solution to financing needs for businesses seeking early-stage funding without immediate equity dilution. However, there can be drawbacks, so it’s vitally important that businesses secure legal advice on the pros and cons before going down this particular route. Much will depend on the specific circumstances of the business and its long term goals.