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Convertible Loan Deals – About to make a comeback?

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:

  • In these uncertain times, valuations are also uncertain. Investors can take advantage of this opportunity by offering much needed finance to companies at a heavily discounted conversion rate when the company undertakes its next financing round. It is not unusual at these times for a discount of 20-50% to be accepted by companies desperate for cash-flow.
  • As the CLN is a debt obligation it can be secured against the assets of the company, including intellectual property rights.
  • High rates of interest can often be applied, where at the next financing round the new investors normally won’t want these sums repaid from their new cash and as a result they also get converted and add to the discount.
  • If the company is wound up, the investor will be treated as a creditor of the business and therefore rank ahead of other stakeholders upon liquidation.
  • There is talk in industry that CLNs made during this crisis will qualify for SEIS/EIS relief. If such a proposal is accepted by HMRC, there is likely to be even further interest in CLNs.
  • An investor may still request similar protections as seen in a traditional equity fundraising round, including:
    • Warranties from the company and founders
    • Board representation (or observer)
    • Veto rights
    • Information rights
    • Pre-emption rights

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:

  • The conversion discount rate (as mentioned, typically this is 20% in the current environment but it can be higher). Additionally it is important to consider the dilution of shareholders if the next fundraising is on a downround (ie: the valuation of the company is lower than the last fundraising round) and the effect of the discount on that dilution (so consider a conversion floor price)
  • What are the triggers for conversion (ie: is it automatic or does the company or investor have the choice to convert)
  • Rights of redemption for the investor. The company would not want to find itself in a similar cash-strapped position if the investor was free to redeem its capital on demand
  • Avoid granting security if you can (especially if you have already granted a security to your bank because the inter-creditor ranking arrangements can get complicated and also seriously slow up the deal)
  • What is the interest rate (we often see 7-15% and keeping it below 10% is key)
  • Does the interest roll-up upon conversion

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.

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