- Short-term debt instruments - CLNs are short-term debt instruments that have the option or requirement to be converted into equity in the future, typically in the form of shares.
- Early stage - CLNs are typically used by angel investors to invest in companies at an early stage of their growth.
- Convertible - Capital, in this case debt, is provided in return for the ability to be converted into equity at a later stage.
- Secured and Unsecured - There are different types of CLNs
- Interest - As Convertible Loan Notes are loans, they come with an interest rate that is often paid for through greater equity in the company.
- Maturity dates - CLNs have a ‘maturity date’ by which the company agrees to repay the note to the investor.
Convertible Loan Notes (CLNs) are short-term debt instruments that have the option or requirement to be converted into equity in the future, typically in the form of shares.
CLNs are typically used by an Angel investor to provide capital to a business at a very early stage of its growth. The ‘convertible’ aspect of the note means the debt can be converted into equity in the company, typically in the form of shares, at a specific future event, often a later round of funding.
There are usually conditions associated with the conversion of the CLN into equity, such as valuation caps and discounts on shares purchased in the future. These act as incentives for the high risk that the investor takes in funding new ventures.
An advantage for investors is that CLNs offer them a way to fund a new company while avoiding the need to value the company in its earliest stages when an accurate valuation may be difficult.
Secured and unsecured CLNs
Secured CLNs are named as such because they require the CLN to be secured against a company’s assets if the company fails to repay the loan. This offers protection to the investor in the context of the high risk investment that are making.
Unsecured CLNs do not require any such agreement. Instead, terms are agreed upon before signing the CLN agreement, the investor (Note holder) provides capital and the company promises to repay the loan or issue the equivalent value in shares. This is unlike an ASA where a company cannot pay back the money invested.
As Convertible Loan Notes are loans they come with an interest rate (typically between 4% and 8%). This determines how much interest accrues on the initial loan amount prior to the note’s conversion to equity. While traditional loans require interest be paid in cash, a CLN note holder can receive payment of interest through greater equity in the company in the form of additional stock shares up to the note’s conversion.
Due to the loan nature of CLNs, they also have a ‘maturity date’ or ‘due date’, typically set three to five years into the future. This is the date by which the company agrees to repay the note to the investor (unless they have already completed a funding round in which the convertible notes were converted into equity).
If the note has not been converted by its maturity date and the company has become profitable and does not require further funding, the note will convert to equity in the company.
Due to this, it is important that the maturity date is set to one where the company feels confident that they will be profitable or will have been able to raise funding so they can convert the CLN into equity and avoid being in default.
It is, however, unusual for investors to call in their CLN on its maturity date, choosing instead to extend the maturity date of the CLN. This is because the consequence of calling in a CLN on its maturity date might mean financial damage to, or bankruptcy of, the company, scuppering any chance of the investor seeing a return on their investment.
If a company fails before the note is converted, the investor’s interest in the convertible note has priority over equity interests and, generally speaking, is first in line for repayment – behind any secured debt in the company.
Things to note
- CLNs are significantly different from ASAs and SAFE notes.
- CLNs are treated as debt and are not SEIS or EIS eligible.
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