Convertible Notes, What are they and how do they work
Always surprises that people still do not understand what a convertible loan note is or how they work. To be fair they are sometimes made out to be quite complex. US Scale up markets love then, UK markets less so.
A convertible loan note (you will also hear people call it a CLN) is a type of debt instrument that enables lenders(VC’s, Angels etc) to convert their loans into equity at some point in the future. This type of financing is often used by growth companies to raise capital without having to issue equity. While convertible loan notes offer businesses with limited access to other forms of capital a viable option, they can also like all things have elements of risk attached. Here are some pros and cons of using convertible loan notes to finance a venture.
1. Ensuring Growth and Retaining Control: By using convertible loan notes, businesses are able to “sell” their debt rather than their equity and thereby maintain complete ownership of their venture. This also allows them to access much-needed capital and finance their growth, without giving away ownership rights or control of their company. A recent example I had on this was a company growing where we are not quite series B, but also series A would have probably proved a challenge and not great for existing shareholders.
2. Achieving Valuation Goals: A CLN can help businesses maximize their valuation since the lenders typically agree upon a conversion price that is higher
3. Convertible loan notes are flexible, allowing companies to take on investor capital without sacrificing ownership or governance rights(further board seats, preferences).
4. These notes offer investors an attractive way to invest in a company in exchange for the potential of a higher return on their investment in the future.
5. Convertible loan notes are often less expensive (in terms of issuing costs) than issuing equity.However, if the structure of the instrument gets complex that it can sometimes cause a delay)
6. Convertible loan notes provide companies with immediate capital, which can be beneficial for businesses in need of short-term funding. Also not subject to tranches of money.
7. The notes can be issued quickly, which may be beneficial for companies who need access to funds quickly.
8. Convertible loan notes can be structured to mitigate the risk to investors, giving them the option to convert their loan into equity at a pre-determined rate if the company is successful.
1. They Are Still Vulnerable to Company Failure: Convertible loan notes are complex financial instruments and they come with a certain amount of risk. The lender is only protected if the company fails and liquidates its assets. This can mean that the borrower will still end up with nothing, depending on the company's financial situation.
2. High Interest Rates: Convertible loan notes come with high-interest rates, which can make them expensive for borrowers.
3. Not For Everyone: Convertible loan notes are not suitable for everyone and require careful consideration. Borrowers should understand the risks involved with taking out such a loan and be sure that it is the right fit for their situation.
4. Potential for Delays: Convertible loan notes often come with more complex structures than more traditional loans. This can lead to delays and complications in the loan process, which can be costly for the borrower.
As point 3 under cons says, not for everyone, however, do not shy away from looking at the CLN option just because it seems more complex then simply doing equity. Also timing may be a factor to consider against runway.
There are also other complexities that most startup and scaleups wont encounter as still too early, but not to go into here, but they do exist and have certain pain that comes with them.
David Murray-Hundley “The Grumpy Entrepreneur"