Convertible Loan Note (CLN)

A Convertible Loan Note (CLN) is a form of debt that converts into equity under certain circumstances, most commonly at a future qualifying funding round. This means investors who loan money to a business under a CLN agreement usually receive equity in the company, at a discounted rate, instead of a return in the form of principal plus interest. 

A Convertible Loan Note is a debt instrument with a mechanism that allows the principal amount (plus interest, if any) to convert into equity at a future date in the following circumstances: 

• a qualifying funding round (as set out in the terms of the CLN)
• maturity (the maturity date is stated in the terms of the loan – at or after this date you either repay the Note or it converts to equity on agreed terms)
• exit (e.g. a sale, merger or consolidation)

You’ll often see a CLN used in funding rounds where the valuation of the company is unknown or uncertain. It can reward investors who come on board early, without causing valuation issues down the line. 

You might come across a CLN as an alternative to an Advanced Subscription Agreement (ASA). You can read more about the pros and cons of a CLN versus an ASA here.

Discount rate and valuation cap

If the CLN converts to equity (e.g. at the next qualifying funding round) the amount of equity that the CLN will convert into depends on the price of the equity at this next round. It also depends on two key elements – the discount rate and the valuation cap. 

• Discount rate: The Note holder gets a share price discount (i.e. more shares) compared to the price paid by other investors participating in the same funding round. This discount on conversion is also found in an Advance Subscription Agreement. The discount rate is typically 15%-25%, and is generally 20%. (Bear in mind if Note holders’ shares end up forming a high proportion of the new shares your company issues, the actual amount of new money you raise in the next funding round could be substantially reduced.)

• Valuation cap: Investors often demand a cap on valuation in addition to a discount on conversion. This cap sets the limit on the conversion price of the Note so that the Note holder is guaranteed a minimum number of shares if, at the next equity funding round, the share price is above the valuation cap. The cap is there to protect the investor but bear in mind that new investors might think twice about investing at a much higher price than the holders of your Notes and might ask them to revisit terms.

Convertible Loan Notes often have zero or low interest rates, or where interest does accrue it’s rolled up and converted into shares along with the principal amount (i.e. ‘capitalised interest’).