For startup founders

Convertible loan notes – top tips for founders of startups

27 November 2018

Convertible loan notes are a great way for start ups to generate an initial chunk of cash in order to advance certain aspects of their business, at the same time as they try to secure a direct equity investment. As a result, convertible loan notes can act as a short term solution to financing needs and, once in place, can be an indication to future investors as to the potential of the business.

The benefits of going down the convertible loan note route are that, generally, the note can be put in place very quickly and the costs associated with doing so are a lot less than those for an equity round investment.

That being said there are certain “red flags” that start ups should be aware of when agreeing the terms of a convertible loan note, to avoid putting off future investors. 

When an offer of quick cash comes along, it can be very easy to allow eagerness for the funds to take over. However, this can result in the founders giving away too much too soon but not realising until it is too late.

Founders should keep in mind that if there is already interest from other investors then there is no need to cave in, if pushed to agree to unreasonable terms.  Equally, if interest from other investors is not yet there, founders should not ruin their chances of securing such future investment by negotiating badly at the initial stage.

Each agreement will, of course, be different in order to fit the situation to which it relates.  However, set out below are some “top tips” for founders of start ups when presented with the terms for a convertible loan note instrument:

  • A convertible loan note will convert into shares according to whatever price is specified in the relevant document. There may be a link between this price (and the discount to the market value at the date of conversion) and certain other terms in the note, including the level of interest applicable, and the terms relating to repayment. The general rule is that where only a low discount applies, then other terms may be more favourable to the investor, and vice versa.
     
  • It is becoming increasingly common (especially when dealing with US based investors) for investors to ask for a conversion price based on the lesser of (1) the agreed discount and (2) a fixed valuation set at the date the loan is made.  Often this fixed valuation will be pitched at a level to make it seem attractive to the founders, but which may seem low in the future, if the business is successful and grows quickly. Where possible, it would be preferable for founders to resist the inclusion of this fixed valuation, or certainly ensure that the figure provided is at an appropriate level.
     
  • An obvious means of avoiding conversion on unfavourable terms is a clause which allows the company to repay the loan (including all interest). For obvious reasons, investors will resist a right of repayment, as this reduces their chances of benefitting disproportionately from the conversion mechanism.    
     
  • An investor will usually want to ensure that at some point the receive equity, which will mean including a longstop date for conversion. There is nothing wrong in agreeing to this but founders just need to make sure that the date is far enough in the future to not cause issues. For example, if it takes longer than planned to secure the full equity round investment the company is looking for, a short longstop date could trigger conversion at a less than convenient moment for the company. 
     
  • Another important point to watch out for as a founder is in relation to equity rights.  Any requests by the note holder to have rights with regard to equity (following conversion of the loan) which are more favourable than the founders and / or future investors should be considered very carefully.  Most direct investors into equity would generally expect to rank equally with the founders of the company not above them and could therefore be put off by another party ranking higher than both themselves and the founders.
     
  • Triggers for conversion are always going to be an important term for both parties, and investors will inevitably want the ability to convert their loan to equity in as many circumstances as possible, in order to ensure they get the most from their investment.   From a founder’s perspective it is always beneficial to try and limit the triggers for conversion to (1) a full equity round investment at a decent level and (2) a change of control of the company.
     
  • It would be unusual for an investor by way of loan note to offer anything more to the company than an immediate injection of cash.  This level and stage of investment is different to a direct investor into equity who is prepared to wait for a return over a longer period, and may even be prepared to work with the founders of the target company to grow the business. The quid pro quo for such a contribution may be a seat on the board, but for obvious reasons any request by a loan note investor for such a right should be resisted.
     
  • Convertible loan notes are often a favourite of US investors.  Founders of UK companies should be aware that the market standard for convertible loan notes in the US is very much focussed in favour of the investor.  It would therefore be common for a number of the onerous terms mentioned above to be included in a draft term sheet from an investor from across the pond.   For this reason that it is important for founders to have a general idea and awareness as to what the market standard is here in England. If not, they may damage their chances of securing further investment from UK investors.

If you would like formal legal advice on convertible loan notes or any other corporate or commercial matter, please contact a member of the start up investments team.

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We welcome views and opinions about the issues raised in this blog. Should you require specific advice in relation to personal circumstances, please use the form on the contact page.

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