What is a convertible loan note? - Inform Direct (2024)

Advantages of convertible loan notes

1. Simplicity

Convertible loan notes are generally simpler and faster to negotiate and execute compared to equity financing rounds. The documentation is less complex and often cheaper to arrange. This can be beneficial for start-ups that need to raise funds quickly.

2. Delayed Valuation

Convertible loan notes can delay the valuation of a company until a later point, such as a future funding round or exit event. This can be helpful for start-ups that are still early stage and may not have a clear valuation yet.

3. Lower Interest Rates

Convertible loan notes typically have lower interest rates compared to traditional debt financing, which can make them a more attractive option for start-ups because they reduce the cost of borrowing.

4. Flexibility

Convertible loan notes can be structured in a way that provides flexibility for both start-ups and investors. For example, they can include terms such as conversion discounts, valuation caps, and interest rate adjustments.

5. Repeatability

Multiple convertible loan notes can be issued to investors under the same governing agreement. This can save time, legal fees and administration costs.

6. Independence

Until conversion, the noteholders are not members of the company and have no voting rights. This means they cannot directly influence the running of the company. In other words, the founders keep control of their company for longer than if they sold straight equity.

7. Ranking in liquidation

As creditors the investors’ unconverted debt takes priority for repayment in the event of liquidation. This can be seen as reducing initial risk. There is a set procedure for investors to recover their loans in insolvency – Creditors’ Voluntary Liquidation (CVL).

Convertible loan notes are generally simpler and faster to negotiate and execute compared to equity financing rounds. The documentation is less complex and often cheaper to arrange. This can be beneficial for start-ups that need to raise funds quickly.

Disadvantages of convertible loan notes

1. Dilution

Convertible loan notes can lead to dilution of existing shareholders’ equity when the notes convert. This can be a disadvantage for start-ups that want to maintain control over their company.

2. Uncertainty

These delayed finance instruments can create uncertainty for both start-ups and investors, as the ultimate conversion price is typically unknown until a future event occurs. This can lead to the value of a convertible loan note ‘ballooning’ in the event of a spike in performance and a high company valuation. If this happens an early investor might become disproportionately powerful.

3. Risk

These loans are a form of debt, which means that they come with risks for both start-ups and investors. For example, if the start-up fails to meet its obligations under the loan, the investor may have the right to take legal action. The terms may contain redemption provisions: events upon which the investor can call in their loan instead of converting it into shares. The company may struggle to repay the loan under these conditions. There can be many other risk factors depending on the specifics of each situation.

4. Complex Terms

The documentation can include complex terms and conditions normally used in stock markets. These may be difficult for start-ups and investors to understand. It’s important to have legal counsel review the terms and make sure that both parties fully understand them before entering into an agreement. Companies should also beware of getting too bogged down in defining the terms to cover every eventuality and satisfy investors, which wastes time and money and defeats the convertible loan notes’ purpose as vehicles for quick cash injections.

5. Lack of tax breaks

Compared with equity, convertible loan notes generally have less favourable tax treatment for investors. For example, there is no EIS/SEIS (Enterprise Investment Scheme/Seed Enterprise Investment Scheme) tax relief. This is because EIS/SEIS can only be claimed when fully paid shares are purchased – it does not apply to future convertibles. Profits from the shares may also be taxed on the investor as deep discounted bonds if they carry a high interest rate and/or redemption premium.

6. Accounting and tax complexity

Factors such as valuation caps, inherent risk and uncertainty, tax rules and specific details in the conditions of convertible loan notes can make them a headache for accountants.

Convertible loan notes can lead to dilution of existing shareholders’ equity when the notes convert. This can be a disadvantage for start-ups that want to maintain control over their company.

How should a convertible loan note be recorded?

The starting point of accounting for most convertible loan notes is to list them on the balance sheet as long-term liabilities. Most convertible loan notes are for a term of more than 12 months, which extends their scope beyond the current accounting period and makes them ‘long term’. They are a hybrid instrument consisting of a debt component and an equity component, and the equity component also needs accounting for in some way before conversion takes place. This area can be challenging to account for. Professional accounting assistance is highly advisable throughout.

Convertible loan notes should be listed on the company’s cap table as the amount of the loan with accrued interest and the maximum number of shares it is likely to convert into.

Whatever happens on the cap table and balance sheet, the register of members should only be changed when the shares have actually been converted and issued, at which point the investor becomes a shareholder.

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