If you are raising funds ahead of a full equity round, convertible loan notes can offer a fast and flexible solution. These hybrid instruments allow investors to provide a repayable loan that may convert into equity later, often at a discount, giving your business much needed capital while delaying valuation negotiations.
In this guide, we explain how convertible loan notes work, the key terms to understand, and the benefits and risks for both founders and investors. Whether you are preparing for a funding round or exploring acquisition finance options, this article will help you decide if convertible notes are the right fit for your business.
If you are considering issuing convertible loan notes or want advice on structuring early stage funding, our experienced funding round lawyers are here to help.
Jump to:
- What’s the difference between a convertible bond and an exchangeable bond?
- Why would a company issue convertible debt?
- When will a convertible loan note convert to equity?
- What are the key conversion terms for convertible loan notes?
- What conversion formula is typically used for conversion loan notes?
- Does the loan in a convertible loan note need to be repaid?
- What are the disadvantages of a convertible loan note?
- Looking to raise investment?
What’s the difference between a convertible bond and an exchangeable bond?
A convertible bond (or convertible loan note) gives the holder the option to convert the debt into newly issued shares of the borrowing company itself. This provides the security and income of a debt instrument while allowing the investor to benefit if the company’s value rises. The conversion feature usually enables the borrower to pay a lower interest rate.
An exchangeable bond instead allows the holder to exchange the bond for existing securities in a different company (often a subsidiary or another company in which the borrower has a significant stake).
For example, if Company A expects its own share price to perform well, it might issue a convertible bond that investors can later convert into Company A shares. If Company A instead owns a large holding in Company B and wants to reduce that investment, it might issue an exchangeable bond that investors can exchange for Company B shares.
Why would a company issue convertible debt?
A company may issue convertible debt for general funding or for a specific purpose such as business acquisition. Because of the conversion feature, borrowers typically pay a lower interest rate than on conventional debt, thus reducing the costs of capital.
Unlike equity investors, convertible noteholders are not shareholders and they will have no voting rights and no direct influence over the company’s operations.
Issuing convertible loan notes is usually simpler and faster than a full equity round. Fewer documents are required and valuation negotiations can be postponed until a later equity funding round or the achievement of commercial milestones.
For investors, convertible debt ranks ahead of equity in an insolvency, making it a safer instrument than shares. If the company performs well, noteholders can convert into equity and share in the upside.
Convertible debt can also be used as part of the consideration in an acquisition.
When will a convertible loan note convert to equity?
A convertible loan note will typically convert to shares if a company is sold or completes a successful round of full equity funding in accordance with the terms of the convertible loan note instrument.
The conversion price is normally set at a discount to the price paid by new investors in the triggering funding round (typically 10–20%). For example, if new investors subscribe at £1 per share, the notes may convert at 80p–90p per share. The exact discount is a matter for negotiation.
If the conversion trigger is a further equity funding round, the noteholders will usually convert their debt into the most senior class of shares offered during that round. Noteholders may also have the option to convert their debt into an existing class of shares at a pre-agreed price if an equity funding round does not occur. Typically, the convertible loan note will include details of conversion on the maturity date (normally on an anniversary of the date of the convertible loan note) at an agreed pre-money valuation.
A company will usually pay interest on its convertible debt at a rate of between 4% and 8% per annum. In reality, interest is rarely paid but rather deferred or ‘rolled-up’ into the amount to be repaid or converted into equity.
What are the key conversion terms for convertible loan notes?
Convertible loan notes may convert into shares automatically following certain events, or they convert at the discretion of the noteholder. The conversion conditions will be contained in the convertible loan note instrument.
Common automatic conversion events include the company raising finance above a certain threshold by a certain date, or the company being sold.
Common discretionary conversion events include the company raising finance below the amount originally envisaged, or if the investor chooses to convert the loan note into equity on the maturity date at the fixed pre-money valuation.
When notes convert, noteholders usually receive the same class of shares (and similar rights) as the new investors, but at a lower effective price. This can make subsequent equity rounds harder if a large proportion of the share capital is already held by former noteholders.
What conversion formula is typically used for conversion loan notes?
Where conversion is triggered by a new equity round, the notes normally convert at a percentage discount to the price paid by the new investors. The notes convert into the same class of shares, but the noteholder receives more shares than the face value of the notes would otherwise buy. The discount compensates the noteholder for providing earlier, higher-risk capital.
The discount rewards the noteholder for investing in the loan notes and for providing a bridge facility to the company ahead of the full equity funding round.
If a company’s sold, and that triggers the conversion, a common conversion formula is for the loan notes to convert into shares at a previously agreed price per share. The company must agree the valuation at which the loan notes convert to shares at the time the loan notes are created.
An investor may wish to include a threshold valuation for the company as security before automatic conversion. Alternatively, an investor may make conversion at its discretion, to avoid holding substantial equity in a company valued less than it originally envisaged.
Does the loan in a convertible loan note need to be repaid?
If a convertible loan note never gets converted into equity, the noteholders will require the company to repay the loan. If the loan note is converted into equity then no further repayment will be required.
The repayment condition may be either automatic or at the choice of the investor. Common events of automatic repayment include:
- Insolvency related events of default
- Failure to repay or convert by the maturity date
- A material breach by the company
If an automatic repayment event is occurs, a noteholder can usually demand immediate repayment of principal plus accrued interest.
The loan note instrument may also provide that the loan notes are to be repaid if the company does not achieve the requisite level of financing within an agreed timeframe. This sort of repayment is normally at the election of the noteholder.
It’s common for loan notes to be repayable at the nominal amount of the loan notes outstanding plus the interest accrued on the loan notes during the term of the loan.
What are the disadvantages of a convertible loan note?
A key disadvantage with convertible loan notes is that several major tax reliefs for investors are not available. For example, the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) only apply where an investor invests in a company’s equity as opposed to making loans, even if they are convertible into shares. This means that investors could miss out on as much as 50% income tax relief on the amount invested when investing in convertible loan notes rather than in shares.
In addition, convertible notes that carry a high interest rate or redemption premium can sometimes be treated as deep-discounted securities, potentially creating income tax charges on conversion or repayment. Specialist tax advice should be taken before proceeding.
Looking to raise investment?
If you’re an entrepreneur looking to raise finance for your business, you may be considering bringing on board an investor, such as a venture capital or private equity firm. If that’s the case, you’ll most likely encounter a range of legal documents as part of the funding transaction, including an investment agreement.
Getting the legal structure and documentation right can help protect your interests, avoid unnecessary delays and put your business in a stronger position when negotiating with investors.
Our experienced corporate lawyers support founders throughout the funding process, from preparing and negotiating investment agreements and term sheets to due diligence, shareholder arrangements and completion.
Planning a funding round? Find out how our corporate fundraising lawyers can help you secure investment and get the right deal for your business, or get in touch with our team to discuss your plans.
