Convertible loan note (CLN)

Quick facts

A convertible loan note (CLN or convertible note) is a short-term loan/debt that is converted into equity at an agreed later date.  Convertible loan notes usually allows the investor to buy equity at a discounted rate.

There are two types of CLN’s: secured and unsecured.
Secured CLN’s secure the loan by using the business assets as collateral in case of non-repayment. This is referred to as a ‘debenture agreement’
Unsecured CLN’s tie the business itself, the owners, and the investors/creditors into what’s called a loan note holder. The parties agree to the terms of the CLN and once signed, the cash is released to the business. In return, the business guarantees to either pay the investor the loaned sum back or shares in lieu of non-payment.

This sets out the date of which the loan amount and interest gained is due. The usual terms of this is 3-5 years from signing of terms.
Qualifying funding round
Convertible loan notes are set to automatically convert when a specific target amount is raised within an agreed time limit. 
If the loan defaulted, interest accrued not paid or another breach of stipulations, this will trigger what is called an event of default. You may lose equity or control of business so it’s critical that debt is satisfied and terms are met to the satisfaction of note holder.

Principal and interest
The convertible loan note is usually calculated using simple interest. Sometimes compound interest can be used, depending on agreement set out between business, owner and investor. The principal amount is due on the maturity date and interest accruing is payable yearly, monthly or quarterly. Furthermore, interest can be payable on the maturity date even alongside the principal if those are the terms agreed.
Discount rate
The terms of a convertible loan note usually include a share price discount, offering the CLN holder shares at a lower rate than other investors. Usually the discount is around 20%, although it can vary from 15-25%, making it an attractive proposition for investors who are confident that the expansion of your business will be a success. 
It is worth remembering, however, that the higher proportion of new shares raised are owned by investors with a discounted rate, the less capital you will have available.
Valuation cap
A valuation cap sets a ceiling on the conversion price of the convertible loan note so the note bearer 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 the 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.

A convertible loan Note could be a practical solution for a growing company that is somewhat undervalued. It is an especially useful form of raising finance between rounds of capital investment. In particular, if your business is projected to grow, existing investors are keen to invest more, a convertible Loan Note may be the right financing for you. A convertible loan note often has zero or low interest rate, or where interest does accrue it is rolled up and converted into shares along with the principal amount (i.e. capitalised interest).

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