Raising Money for Early Stage Companies: An Introduction to Convertible Loans
A convertible loan is a short-term loan to a company which is converted into equity at a future date, usually triggered by a subsequent fundraising. It may also be redeemed and repaid in the same way as a commercial loan.
Convertible loans are a mechanism which can be used by early stage companies to raise funds from investors – and will typically be used to provide working capital in anticipation of a full funding round. In the UK most convertible loans take the form of convertible loan notes.
There are a number of similarities between convertible loan notes and advance subscription agreements.
Like any commercial loans, the terms of a convertible loan note instrument will be carefully negotiated between the parties. However, given the various permutations that can apply upon conversion or repayment of a convertible loan, there are some additional issues that need to be considered. Because of this, expert advice should always be sought to ensure that each party's interests are suitably protected.
What are the key features of a convertible loan note?
The primary features of a convertible loan note are that:
- It will convert to shares in the company on the occurrence of an agreed event, which will typically be either a qualifying finance round or an agreed date (typically set 12-24 months from the grant of the loan).
- The conversion price will be determined by that future event. The terms of the conversion price will depend upon the negotiating positions of the parties, but will normally be either (1) a price agreed between the parties or (2) a discount (of typically 10-30%) against the price achieved in a qualifying finance round.
- It is interest bearing. Unlike an advance subscription, which is simply an equity investment for shares (which are then issued in the future), a convertible loan note may accrue interest on the principal amount advanced and can therefore offer the lender a potential return on their investment from day 1.
- It is redeemable. There will typically be a range of circumstances in which a lender will be entitled to redeem the loan rather than allowing it to be converted into equity. For the reasons outlined below, this can offer various benefits to both the investor and the company.
- It will not qualify for EIS relief. Unlike equity investment or advance subscriptions, convertible loan notes cannot qualify for EIS relief. As discussed below, this can have a significant impact on when they are considered suitable.
What are the key terms to be negotiated?
There is no one-size-fits-all when it comes to negotiating a convertible loan note instrument, but generally a convertible loan will include some or all of the following terms:
- The 'threshold' or 'floor' which will constitute a qualifying financing round for the purposes of automatically converting the loan into shares. An investor will want this to be set sufficiently high to avoid the company being under-funded, whereas the company will want to ensure that they are able to achieve a qualifying financing round within the agreed timeframe.
- Whether there should be a valuation cap (i.e. the maximum price at which the loan will convert to equity). A cap would protect an investor in the event that the company's valuation increases rapidly. Increasing the cap will reduce the amount by which the shareholders' equity will be diluted if the conversion takes place at the capped share price.
- The interest rate will be a keenly negotiated aspect of a convertible loan note. It will reflect the risk being assumed by the investor, which is generally perceived to be fairly high given that early stage companies are generally not profitable, have limited assets and will often require the convertible loan as a form of bridging finance. The company may also be keen to negotiate a position whereby interest only accrues if the loan is redeemed (rather than converted into equity) to reflect the fact that it is arguably a prepayment for shares rather than a pure commercial loan.
- Interest may not be payable as it accrues, and can be rolled up and added to the principal amount outstanding. The effect of this is that interest will become payable on redemption or – where applicable – effectively increase the number of shares that are issued to the investor on conversion of the loan
- Whilst convertible loan notes are inherently flexible, an investor will typically want as much control as possible over whether the loan is converted or redeemed. Conversely, the company will want to achieve as much certainty as possible to ensure that the existence of the convertible loans doesn't jeapardise the completion of future funding rounds or an exit, and will usually want the loan to automatically convert in a wider range of circumstances.
One practical step for the company is for the board to ensure that it maintains sufficient authority to issue shares upon the conversion of the convertible loan.
What are the benefits of a convertible loan?
From the company's perspective there are numerous potential benefits to issuing convertible loan notes to investors, including:
- Quickly and inexpensively securing funding that will enable the business to continue trading until further fundraising or an exit can be secured.
- Attracting a broader range of potential investors through offering a healthy yield and a greater measure of control than a traditional debt or equity investment – particularly as investors may be able to convert or redeem their loan.
- The ability to defer interest payments – which is not normally possible under a commercial loan – which directly benefits the company's cash flow.
- Deferring valuing the company, which provides time for the share price to increase. This can benefit current shareholders by reducing the amount of equity that they are required to give away to an investor when compared with issuing shares at the company's current share price.
- Avoiding granting any information or veto rights to an investor until the investment is converted into shares, giving the founders greater autonomy and independence to grow the company in the meantime.
- The possibility of the convertible loan being redeemed, rather than converted, would avoid the current shareholders' equity being diluted.
From an investor's perspective, granting a convertible loan can provide the following benefits:
- The possibility of securing a discounted share price on a subsequent fundraising round or exit.
- Upside protection – where applicable, a valuation cap will limit the share price at which the loan will convert even if the company experiences explosive growth.
- Downside protection – the possibility of the loan being repaid rather than converted may be more attractive to the investor where the company has underperformed and the share price has fallen below an acceptable level.
- A stronger position if the Company becomes insolvent (as unsecured creditors rank ahead of shareholders) – although in reality most early stage companies have very limited assets which could be realised on insolvency.
The primary disadvantage of convertible loans is that they do not entitle the lender to qualify for EIS relief. In circumstances where the availability of EIS relief is essential to an investor, an advance subscription agreement will generally be more appropriate. However, if the company does not intend to be or remain EIS-qualifying and/or the investor is not EIS-qualifying then there will be no need to comply with the stringent requirements of EIS legislation – which may be seen as an advantage by all concerned.
Care should also be taken to ensure that convertible loan notes do not prejudice the availability of future investment from third parties. When a company needs to raise funds very quickly it can be tempting to agree terms which are not in the company's best interests which may very soon cause problems when discussions begin with potential investors.
Find out more…
Given the potential benefits and pitfalls of convertible loan notes it is always prudent to get expert advice before agreeing heads of terms or committing to the form and content of the investment documents.
This article is for general information only and does not, and is not intended to, amount to legal advice and should not be relied upon as such. If you have any questions relating to your particular circumstances, you should seek independent legal advice.