Startup Life/Funding/Analysis/ Convertible loan notes: What are they? And should you take one? The good, the bad and the term sheets By Steph Bailey 9 March 2023 Anthony Rose, founder and CEO of legal platform for startups SeedLegals Anthony Rose, founder and CEO of legal platform for startups SeedLegals \Startup Life The UK business loans and grants available for startups By Jessica Rawnsley 24 March 2023 Startup Life/Funding/Analysis/ Convertible loan notes: What are they? And should you take one? The good, the bad and the term sheets By Steph Bailey 9 March 2023 This is the scenario: you’re a startup founder and need some funding to fuel your US expansion plans. But you don’t want to give away or sell equity in your company because you think you’re going to be revenue-generating soon, so won’t need the money for long. One solution: a convertible loan note. If you can repay it, you will, but if you can’t, then it’ll convert into equity. This is a good use case for convertible loan notes — but there are also instances where it’s best to avoid them. Here’s what you need to know about the instrument, from common deal terms to the pros and cons of taking one. What are convertible loan notes? You can think of a convertible loan note as a type of investment that sits between borrowing and equity. “A convertible loan is a loan agreement between an investor and a company that’s granted by the investor, that will ultimately either get paid back (that’s why it’s a loan agreement) or it will convert into equity, usually shares (that’s why it’s convertible),” says David Zwagemaker, partner at Peak, a founder-funded VC firm based around Europe. According to Anthony Rose, founder and CEO of legal platform for startups SeedLegals, which offers convertible loan notes, most convertible notes issued by VCs are unsecured — which means a lender provides money to a borrower without any legal claim to the borrower’s assets in case of default. Secured notes are when the lender has a legal claim against the borrower’s assets. “A secured note simply gives the noteholder(s) security over the assets of the company and therefore some form of priority if the note isn’t repaid or converted,” says Mike Turner, emerging companies partner at law firm Latham & Watkins. “Often with tech startups, security of this type is relatively meaningless as the company’s assets have little value when the company is early stage.” More specialised debt providers are incorporating convertibles into their offerings, and these are more likely to be secured. Silicon Valley Bank also offers secured convertible loans, but currently only in the US. How do convertible loan notes work? What are the typical terms of a convertible loan note? Common convertible loan note terms include interest and a maturity date — the date on which the final loan payment must be made. According to Michael Blank, head of the investment team at VC firm Verve Ventures, interest rates are usually between 2-10%. The maturity date is also important for founders, he adds, as “the longer the maturity date, the higher the interest and the discount at the end”. Rose says the UK’s Future Fund, which has issued hundreds of millions of investments via Future Fund convertible notes, set a standard: “8% simple interest, three-year maturity.” Another common convertible loan note term is a discount, which is a percentage reduction at which the note will convert relative to the next round. So, for example, if a company sells shares at £1 per share but the discount rate on its convertible note is 20%, new investors would have to pay full price while the convertible note holder would be able to purchase shares at £0.80. “I would say market standard [for a discount] is somewhere between 10-30% depending on the situation of the company,” says Blank. “What you often also see is a staggered discount, depending on when the conversion happens.” Sometimes, but not always, convertible loan notes may also have a cap, meaning they convert into equity once your startup hits a certain maximum valuation. So, for example, if you took a convertible loan note as a seed-stage company with a 12-month maturity period, and in that time you raised a Series A which took you past the maximum valuation, the loan would then convert before the maturity date. There may also be terms relating to a qualifying financing round — which is the maximum size of a round you’re able to raise before the loan converts. Less commonly, you may also see a reduction premium attached to the terms of the loan note, which means that if the loan note gets to maturity or repayment, there might be an additional compensation due to the provider. “Convertible loan notes can be a red flag” Rose notes that terms are usually more strict if a convertible loan note is being used as a last resort. He says these situations are sometimes called “last man standing” — where you ask existing investors to top up their investment and one investor (typically in a sea of disinterest) says they’ll offer a convertible note and the terms state that it’ll convert when you raise your next round, but if you don’t they’ll get 51% equity in a certain number of months. “Convertible loan notes can be a red flag,” says Rose. “Essentially it’s a last-ditch attempt — if things go well you rescue the business, and if things don’t go well, the person — as a payoff for their risky investment — takes control.” When does a convertible loan note… convert? The intention of a convertible loan note is often to convert before a startup has to pay the full loan back. This is known as a conversion event, says Jean-Laurent Pelissier, director of strategic capital for Silicon Valley Bank UK. Jean-Laurent Pelissier “There’s lots of types of trigger events that might create the conversion,” he says. “Typically it’s on the next equity round or it could be an exit event such as an IPO or an acquisition. But there could be some other scenarios, it could be based on a pre-specified amount of time or it could be done at the maturity of the loan note.” Who’s taking loan notes? For Zwagemaker, the most common times where convertible loan notes are used are at pre-seed — where companies or investors don’t want to put a price on their startup yet because it’s too early stage — or bridge rounds, which is when a company raises extra money between priced rounds. “VCs use it more in bridge round scenarios,” says Zwagemaker. “We quite often also do convertible loans in companies we’ve already invested in, so let’s say a company will want to do a Series A but we feel they’re not quite there yet and we want to give them six more months of runway.” Given the market is choppy, Rose says more companies may be after runway, but they could end up in a risky situation if they take a convertible loan note. “There might be more bad circumstances where companies are struggling to raise a funding round and then turn to that last man standing, who hops in and offers the convertible note, and they end up taking control of the company,” he says. Latham & Watkins partners Shing Lo (left) and Mike Turner Shing Lo, another partner at Latham & Watkins, agrees convertible loan notes are now riskier. “They can complicate the terms of future priced rounds because they carry discounts to the price of that round,” she says. “Also, if you do one convertible after the next — the multiple convertibles (especially if they are on different terms) can complicate the [equity] conversion.” Zwagemaker adds, in his experience, that convertibles are being used in the sort of scenario where “everyone is still believing everything is going well”. But another result of the downturn has been higher interest rates. “Interest rates have gone up, also in convertibles,” he says. “A couple of years ago you saw 4-5%, and it’s gone up to 8-10%.” What are the benefits of convertible loan notes? You don’t have to put a valuation on your company. “It might be your company is super early stage and you just don’t know the valuation, or it might be that the company has got a bit of a crisis going and the valuation will become zero or something huge,” says Rose. This can be “particularly helpful in an environment of challenged valuations,” says Turner. It’s usually quicker than VC investment, say Zwagemaker and Blank. It’s a “relatively easy document” to read compared to investment agreements and shareholder agreements, says Zwagemaker. You can use it as an incentive, says Blank: “You can incentivise existing investors by saying ‘hey. we’re opening up this convertible now, shortly before our equity round, if you participate you get a 10% discount on the other side’.” Are there any negatives? “You get the money right away, but you don’t get the pain from dilution right away,” says Zwagemaker, noting he’s seen companies stacking up convertible loan note after convertible loan note before feeling the dilution at the other end. You can end up bankrupt. “The problem with borrowing money is unless you’ve got a revenue stream, you can’t pay it back, it’s going to bankrupt you,” says Rose. You’re providing an instrument that converts into equity but you’re not really sure what the terms of the equity are going to be, says Pelissier. They are quite complicated and expensive to set up, says Rose. All these things could put off new equity investors. “You have a convertible sitting there that has high discounts or punitive terms, it could really impact your ability to close or at least close on decent terms,” says Pelissier. So, should you take one? Once upon a time, convertible notes were the only gig in town. But now there are lots of other financing options — including convertible loan notes’ little sister and pure equity agreement Advanced Subscription Agreements (ASAs) — which is where investors “prepay” for shares that are issued at a future funding round. However, done in the right circumstances, convertible loan notes are creative instruments that can help startups grow and get to a place they want to be. If you’re stuck, Pelissier suggests you seek the advice of a lawyer or a tax adviser. “It’s really for very specific and niche situations,” he says. “But we have definitely seen an uptake in more of them being done today than there were three, four years ago.” Steph Bailey is Sifted’s head of content and coproduces Sifted’s flagship podcast. 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