Convertible loan agreement: pros and cons for startup funding

A convertible loan agreement allows you to take a cash loan from investors, which can be turned into equity at a later date.

In this article, we’ll break down the key things you need to know about convertible debt and how to use our own version of the agreement, the mighty SeedNOTE.

This article covers:

• What exactly is a convertible loan note?
• How does a convertible loan work?
• Advantages of a convertible loan for investors
• Disadvantages of a convertible loan for investors
• Advantages of a convertible loan for companies
• Disadvantages of a convertible loan for companies
• How to set up a convertible loan agreement
• Talk to the funding experts

What exactly is a convertible loan note?

A convertible loan note is a short-term debt instrument. Often, when people talk about convertible notes they actually mean a convertible loan agreement, so it’s worth starting by getting the terminology straight.

Convertible loan note definition

A loan note is, essentially, a security. To create this security, the company will put in place a set of terms on which it is ready to borrow money. For example, the company can create 10 notes of £1,000 each in the hopes to raise £10,000, and it will describe the terms of issuing these notes in a ‘convertible loan note instrument’. One or more investors will then be able to buy (or subscribe to) the notes by sending the money and getting a note certificate in return. The note certificate proves their right to either get the money back or have the loan converted into the shares in the company, depending on the terms of the note.

Difference between convertible loan notes and agreements

A loan agreement is a contract between the company and an identified investor (or investors), which means that there is no need to create any ‘notes’: all the terms are found right there, in the agreement.

So, loan notes and loan agreement are simply different forms of an arrangement where the company borrows cash, on the terms that have been set by it and accepted by the subscribers (note) or agreed between the parties (agreement). In startup financing, it is common for this debt to be convertible into shares.

Depending on its terms, the convertible debt can be converted into shares when certain events occur, typically at the next funding round. But it can also be ‘redeemed’, which means that you need to repay the investment amount in full, with the agreed interest, if any.

Convertible loans can be a useful way for early-stage startups to raise capital. Investors might be more willing to take a chance on an interesting, promising but inexperienced company, because the option to get their money back is built into the agreement.

If the company does well, the investor gets equity (often at a discount) in a fast-growing company. If the company underperforms and doesn’t hit the negotiated milestones (eg, a successful funding round), the company pays back the money.

How does a convertible loan agreement work?

At its simplest, the convertible loan works as an IOU to investors for shares at a future funding round. If the company successfully raises a funding round of a predetermined amount before the maturity date, the debt automatically converts into shares.

You and your investor will need to agree on all the terms under which the debt turns into shares. Typically, the triggers for turning debt into shares include:

• a new funding round
• the maturity date (unless terms specify this triggers repayment of the loan)
• the sale of the company
• IPO

The convertible loan agreement will also specify the circumstances in which the debt needs to be repaid. Typical terms that trigger repayment of the loan include:

• a material breach of terms of the convertible loan agreement
• passing the maturity date when no new funding round has happened (unless your terms specify this triggers conversion)
• your company goes into administration, liquidation or is dissolved

💡 Read more: When will a SeedNOTE convert and when does it need to be repaid?

Now let’s look at the other terms you’ll need to specify in the agreement:

Discount

To sweeten the deal for investors, you can offer a discount on shares to investors who come in early via a convertible loan. This would mean that their debt converts at a lower price-per-share than that paid by new investors in the round. On SeedLegals, the most common discount to offer is 10 to 20%.

Valuation cap

A valuation cap – ie, a maximum price per share at which the debt converts – allows investors to benefit more if the company’s value turns out to be higher than anticipated in the next round of funding.

You would typically set the cap to the expected valuation of the company at your next funding round.

Maturity valuation

If you don’t raise a new funding round before the maturity date, then this is the valuation at which the debt will convert. It’s important to choose this valuation carefully or you could end up giving away a lot of equity.

You might for example set the maturity valuation to the valuation of your last funding round, or perhaps pick a valuation halfway between your previous valuation and your expected next valuation at your next round.

Interest

Interest is another way that some investors might seek to de-risk their investment. The debt tends to accrue interest over time until conversion or the maturity date.
With the SeedLegals SeedNOTE, you can specify whether your company pays this as a lump sum after the maturity deadline or periodically over the term of the loan.

Funding round amount

As part of the agreement, you should specify what amount constitutes a new funding round. This avoids every small incoming investment triggering the conversion into equity.

Advantages of a convertible loan for investors

Convertible loans give investors specific protections and a way to secure a discount on a future funding round.

• Limits risk – a convertible loan agreement allows investors to hedge their bets. If the company doesn’t meet its growth targets by raising a funding round, they can get their money back plus interest. But if the company thrives, their loan converts to equity and they get a stake – often at a discounted price.
• Better value – if the company gains traction, it can prove more valuable for the lender to get shares in the company instead of being repaid.
• Make money through interest – The agreement typically comes with interest, which the company pays to the investor. It’s a small but reliable way for the investor to get guaranteed value from their investment.
• Ahead of other investors at liquidation – this is a debt instrument, not an equity instrument – and if your company is insolvent or looking to liquidate or wind up, debt ranks higher than equity – so if there’s money available, lenders get paid (with interest) ahead of any shareholders.

Advantages of a convertible loan for companies

Convertible loans can be a powerful tool for fast, agile fundraising.

• Fuel for growth – a convertible loan allows you to take in one-off investment ahead of a full priced funding round. This is a faster way to bring small amounts of money into your company, because the terms are simpler to negotiate than a full funding round.
  It also allows you to raise more when opportunities arise and lock in investment when you find an enthusiastic investor – rather than waiting for when you’re ready for a round.

• No valuation needed – you don’t need to commit to a valuation at the time of your investment. When you’re early-stage, it’s often hard to settle on a convincing number.
  Plus, you can use the money you raise through a convertible loan strategically to grow your valuation before a funding round.
• Attractive to risk-averse investors – if your startup has a high risk profile, you might find convertible loans a helpful way to bring investors onboard.
• Lower interest rates – convertible loans typically come with a lower interest rate than other forms of debt financing, such as taking out a bank loan.
  More flexibility – convertible loans allow for flexibility on terms. There’s no one-size-fits-all expectation, so you can negotiate discounts, interest, maturity dates and valuation caps to reach a good compromise with your investors.
• Non-diluting, if you repay the loan – if your terms allow for it, the convertible loan can be a source of non-dilutive startup funding. If you have the option to repay the loan rather than convert it at maturity, you can avoid diluting shareholders.

Disadvantages of a convertible loan for companies

• Costs you money through interest – unlike straight equity financing, taking funding through a convertible note can cost you money if you have to pay interest.
• Strain on your cash flow – repaying the loan and interest payments takes money away from your company’s growth activities. Your company must be able to pay back the original investment amount plus interest on maturity, if your terms don’t allow you to convert the debt into equity.
• Not compatible with SEIS/EIS – this could limit your pool of investors, especially among UK early-stage investors.
• Not as founder-friendly as SeedFASTs – if you’re looking for quick and simple one-off investments, interest-free, advanced subscription agreements (SeedFASTs) might be the better way to go.

How to set up a convertible loan agreement

It used to be expensive and complicated to raise capital by convertible debt. With SeedNOTE, it’s fast and simple. You can create one agreement to which you can add multiple investors. All you need to do is:

• set the terms of your agreement (such as maturity date, interest rate and when/if the loan converts into shares or must be returned)
• add your investors and their investment amount
• send the agreement to all investors to e-sign
• get unlimited expert help at every step

SeedNOTE is a simple way to keep all your convertible loan legals in one, easy-to-use workflow.

Talk to the funding experts

Got questions about convertible loans? We’ll convert them into answers. Book a free call with one of our funding experts or hit the chat button.