Prior to and during the Global Financial Crisis, convertible loan notes (CLNs) were frequently used by investors to de-risk their investments in high-growth and high-risk businesses.
Following that crisis, CLNs lost their appeal for various reasons as the market shifted toward traditional equity fundraising models, alongside venture debt for leverage. In past 12-24 months, CLNs have been quietly been making a comeback and given Covid19 and the government’s recently announced CLN co-investment scheme to cope with the Covid19 crisis, we think CLNs will become in vogue once more.
Convertible Loan Notes – the basics
CLNs are issued by a company to investors as a debt obligation which then converts into shares (thereby removing the debt obligation) at a pre-agreed valuation upon the closing of the next equity fundraising round or exit. The kicker for the company is that, if the equity fundraising round is not closed by the agreed longstop date, the obligation to repay the debt (and any interest) remains. This debt obligation could also be secured by the company by way of a legal charge, assuming the company has any assets to charge.
In the decade post-GFC, where angel and VC investment was relatively plentiful, the balance of negotiation shifted in favour of investee companies. This meant companies were able to raise funds on more favourable terms and, for those good investments, investors were prepared to take on more risk by foregoing the initial debt and taking equity from the outset. This made CLNs redundant. HMRC also deemed SEIS/EIS relief was not available for CLNs, which further accelerated the market shift away from CLNs.
Why CLNs are making a come back
Even prior to the current crisis, the balance of negotiation was slowly shifting back towards investors as their risk appetite started to wane. In particular, we were seeing more bridge rounds and emergency fundraisings where founders had not given themselves sufficient runwaybefore the next round. The instrument of choice for these investors was typically a CLN, or an Advanced Subscription Agreement if EIS relief was needed. Covid19 has caused investors to become even more cautious, and thereby turning to CLNs as the preferred investment instrument.
As an investor, why would I choose to invest using a CLN over another instrument:
As a company being offered a CLN, what terms should I be accepting?
Companies should not view CLNs as being the last chance saloon. They are an efficient mechanism to release cash flow quickly without needing to go through a potentially lengthy and complex equity funding round. They also offer investors the incentive and reward for investing early in companies at a time when access to cash is more challenging. As a recipient of a CLN, our suggestion would be to focus on the following proposed terms:
Either as an investor or investee, we would be delighted to discuss any of the above and whether a CLN would be suitable for your business or investment needs.