A convertible loan note starts life as debt and is designed to end life as equity. The investor lends money to the company now, and at a later event, usually the next funding round or a listing, the loan converts into shares instead of being repaid in cash.
It is one of the most widely used instruments in early and growth-stage fundraising worldwide, largely because it lets a company raise without agreeing a valuation today. That convenience is real. So are the traps, most of which sit in a handful of clauses that founders skim and investors read closely.
Why companies use convertibles
The main reason is timing. Agreeing a valuation for a young company is hard, slow and often contentious. A convertible defers the question to a later round, when a lead investor will set a price based on more evidence.
Convertibles are also quick and relatively cheap to document compared with a full equity round, which makes them popular for bridging: keeping a business funded between rounds, or through the months before a listing.
For investors, the appeal is a creditor’s position while they wait, and a reward for going in early when conversion happens.
The discount
Most convertibles convert at a discount to the price paid by new investors in the next round. If the discount is 20% and the new round prices shares at 1.00, the note holders convert at 0.80.
The discount compensates the early investor for taking risk before the company had proved as much. Typical discounts fall somewhere between 10% and 30%, depending on the stage and how long the investor is likely to wait.
The valuation cap
A cap sets the highest valuation at which the note will convert, however high the next round is priced. If the company raises at a much higher valuation than expected, the cap protects the early investor from being diluted into a tiny stake.
Where a note has both a discount and a cap, the investor usually converts at whichever gives the lower price. Founders should model both outcomes before agreeing either figure. A low cap can hand away far more of the company than the headline discount suggests.
Interest
Convertibles usually carry interest, but it is rarely paid in cash. More often it accrues and converts into shares along with the principal. That keeps cash in the business, but it also increases the number of shares issued on conversion, which is worth factoring into the dilution maths.
Trigger events
The note should say exactly what causes conversion. Common triggers include:
- A qualifying funding round. Usually defined by a minimum amount raised, so that a small top-up does not force conversion at an unhelpful price.
- A sale of the company. Often the investor can choose between conversion and repayment, sometimes with a premium.
- A listing. Conversion into listed shares, typically at a discount to the listing price. See IPO readiness for what that route involves.
Vague triggers produce disputes. Precise definitions avoid them.
Maturity: the clause that matters most
Every convertible has a maturity date: the point at which, if no trigger event has happened, the loan falls due. This is where many convertibles quietly turn back into ordinary debt.
If the next round has not happened by maturity, the company may owe the full principal plus accrued interest in cash, exactly when it is least able to pay. Some notes instead convert automatically at a pre-agreed valuation, or allow the parties to extend.
Founders should read this clause as if the round will be late, because rounds often are. Investors read it as their protection if the company stalls.
Convertibles and SEIS/EIS
For companies raising in the UK, a standard convertible loan note will generally not qualify for SEIS or EIS relief, because the schemes require investment in new ordinary shares, not debt. Some companies use advance subscription agreements instead, which are structured differently. The rules are technical, so take specialist tax advice before relying on either. We cover the schemes in SEIS and EIS: the differences that matter.
When a convertible fits, and when it does not
A convertible works well when a priced round or listing is genuinely in sight, the company needs capital to reach it, and both sides would rather let the market set the price.
It fits less well when there is no credible next event. In that case the note is really a loan with an equity option attached, and it should be judged, and priced, as debt. Our guide to what investors look for in a loan note applies in full.
A simple checklist before you issue
- Model conversion at the cap and at the discount, and at a lower-than-hoped valuation.
- Define the qualifying round precisely.
- Decide what happens at maturity if nothing has triggered conversion, and make sure the company could live with it.
- Agree how accrued interest is treated.
- Check the rules on promoting and offering the note in each country where investors are based.
Handled well, a convertible is a fast, fair way to fund a company to its next milestone. Handled carelessly, it becomes the most expensive capital the company ever raises.
Mark Johnson is a Director of BDM Wealth Management, which introduces capital raising opportunities across bonds, loan notes, IPOs and SEIS/EIS. To discuss a raise, get in touch.
BDM Wealth Management is an introduction business and is not regulated. This article is general information, not financial, tax or legal advice, and does not constitute an offer or invitation to invest. Capital is at risk and you may get back less than you invest. Tax treatment depends on individual circumstances and may change. For high-net-worth and sophisticated investors only. Take independent professional advice before making any investment decision.