A Convertible Loan Note (also known as a Convertible Note, or CLN) is a type of short-term debt that is converted into equity shares at a later date. Making an investment into a startup via a Convertible Loan Note typically allows the investor to receive a discounted share price based on the company's future valuation.
Is it debt or equity?
Investment into a company via a Convertible Loan Note (CLN) is not for equity initially. However, it is essentially a loan to the business that has the option or requirement to convert to equity shares at a price that is yet to be determined. The valuation is not usually defined when the investment is made. It is usually also possible for the loan to be repaid in certain circumstances including any coupons.
When will I receive shares in the company?
Conversion into equity occurs on the next qualifying funding round or when a certain date or duration is met. What is classed as a qualifying funding round will be set out in the terms of the Convertible Loan Note.
At what price will the investment convert?
The price per share that will be allocated is not always a complete unknown. There is sometimes/usually a maximum share price stipulated in the term sheet. Shares may be issued at the lower of the max share price or a discount on the next qualifying funding round.
What is the coupon?
The coupon is the amount of interest that accrues while the loan note is unconverted. This is set out in the term sheet and may accrue daily, monthly or annually. Occasionally, the terms are such that this interest can be paid out in cash and others may offer the return of the principal also. Other times the interest is added to the amount of investment paid on the outset and on conversion the total will be converted into shares.
Please note, not all CLNs have a coupon attached and it is important to check the term sheet in each case to see which the company is offering.
Under what circumstances is the investment repaid?
There is a longstop date by which the investment must be converted into shares. If the company has not reached the funding target set out in the term sheet to trigger conversion by the longstop date, the investment plus any interest is usually repaid in full. There may also be other causes for default set out in the term sheet or it may be chosen by the investor upon conversion.
What if I want my investment to be converted into equity before they hit their target for a conversion event?
In some cases, it is possible to notify the company at any point to convert the investment into shares at the max price set out in the term sheet. This will be highlighted in the term sheet.
What if the company is sold before a qualifying funding round and my investment has not been converted into shares yet?
In the event of a sale of the company before a conversion event, usually the company will issue a conversion notice and a redemption notice for investors to decide which to opt for. Please note, each CLN will have different terms around this and it is important to check the term sheet in each case.
Is the CLN secured?
In some cases, the CLN is secured, however, most likely it will not be as it is usually thought of not as a debt instrument but rather as prepayment for shares.
What class of shares will my investment be converted into?
Each term sheet will be different. Occasionally, companies request for the share class to be selected when making the initial investment. Other times, it is to be selected on conversion.