Convertible Loan Notes used to be complex and expensive to create. SeedLegals has made that much easier, say hello to SeedNOTE!
What is a Convertible Loan Note?
Convertible Loan Notes are short-term debt instruments, not equity instruments. They differ greatly from advance subscription agreements (also known as ASA or SeedFASTs). We’ll discuss that in depth below.
Types of Convertible Loan Notes
Broadly, there are two types of CLNs:
Secured CLNs require you to secure the loan by promising your assets if you fail to repay the loan. It’s a high risk investment, so your investor will want as much protection as they can get. These are more commonly known as debenture agreements. SeedLegals does not deal with debenture agreements (yet) so this article is focused on the second type, unsecured loan notes.
Unsecured loans are fairly straightforward:
- The parties to the agreement are the Company, the founders and the investors.
- The investors are called Loan Note Holders or a Note Holder.
- You agree on terms and sign a convertible loan agreement.
- The investor sends cash to the company.
- The company promises to either pay the investor back or issue shares in lieu of the loan amount.
What are the key terms in a CLN?
Here are the key terms you’ll see in a Convertible Loan Note, which we call a SeedNOTE on SeedLegals:
This is the date on which the loan amount and any accrued interest is due. It’s usually set at 3 or 5 years from the date of the agreement.
Qualifying Funding Round
The Convertible Loan Note automatically converts when you manage to raise a specific amount of funding within a specified period of time. For example, you raise £100,000 on a Convertible Loan Note and set the Qualifying Funding Round at €500,000. The date within which you raise the €500,000 is 30th January 2023. You raise €500,000 on 10th December 2022 – your Convertible Loan Note automatically converts to equity on 10th December 2022.
Principal and Interest
In the simplest form, the Convertible Loan Note is calculated using simple interest. A variation is when your investor asks for compound interest. Your principal amount is due on the Maturity Date, while interest accrues and is payable on a monthly, quarterly or yearly basis. Sometimes, interest is payable on the Maturity Date along with the principal amount.
Event of Default
What happens if there’s a breach of the agreement, or you fail to pay the interest within the specified time? You hit what’s called Event of Default. The list is long and often highly negotiated.
Events of Defaults are tough negotiation points, so be sure you know what you’re getting into before you sign on the dotted line. It might result in your company being taken over by the convertible loan note holder, so speak to us if you’re not too sure what it means!
The Convertible Loan Note holder does not hold shares on completion of the round. Often, investors ask for a discount on the Qualifying Round share price. So, they get the principal + accrued interest + additional shares in lieu of the discount.
Share Certificates and other filings
No share certificate will be issued, no SH01 will be filed. The investors will, instead, each receive a Note Certificate, and SeedLegals includes this in the full suite of documents.
If the Convertible Loan Agreement hits a Qualifying Funding Round, however, you do issue equity at the time of completion of that funding round. Use our Seed Round package, so you know everything is taken care of.
You can read our full guide to SeedFASTs here.
Key things to think about
Before you decide that the Convertible Loan Note is the way to go, factor in the following:
- Does your investor want to give you a loan that can be paid back? If the answer is no, you’re looking for a SeedFAST, not a SeedNOTE.
- Will the company be able to pay the principal + interest on Maturity? If the answer is no, speak to your investor and find out what their terms are for the investment amount.
- If you reach an Event of Default, how much equity are you giving away?
Investors are attracted to Convertible Loan Notes because debt ranks higher than equity if your company is insolvent or looking to liquidate/wind up. Another reason Convertible Loan Notes are favoured is because it gives the Investor their money back if the company fails to raise a Qualifying Funding Round. So, think about it before you agree to the terms.
If you have questions, you know where to find us!