Convertible loan notes (CLNs) are a popular way for start-ups to raise finance with investors – especially for startups without proven revenue streams. Generally, they are a form of loan that can be converted into shares at a later date at the company’s discretion – at specific rates or in response to particular events. 

They will generally be redeemable as well as convertible. They can be secured, although often are not.  If they are unsecured then they will rank alongside all unsecured creditors in the event of a liquidation.

The coupon (interest rate) typically payable under CLNs will be higher than an investor could expect if they placed their money in a high-street savings account.

Interest under CLNs will usually be payable periodically, but it is possible to agree, for example, that interest be rolled-up and paid when the loan itself is converted or redeemed. Interest may also be capitalised if the CLNs are converted.

Whether or not an investor chooses to redeem his or her convertible loan note at the relevant time will depend on several factors, but primarily on the conversion price.

This would typically be set at the notional market value at the time the CLNs are created, or the actual value if the issuer’s shares are publicly traded.

If this market value has risen over time then an investor will generally want to convert his loan into shares. If this market value has fallen then it is likely that he will wish to redeem their loan for cash. Any interest still outstanding will be dealt with in the same way as any principal.

It is self-evident, but in the event that CLNs are converted then existing shareholders (everything else being equal) will suffer dilution, and in the event that CLNs are redeemed then the issuer will have to find the cash to redeem them.

In summary, convertible loan notes are a good way for issuers to raise money because they are attractive to potential investors, allowing them to achieve a healthy yield and obtain the benefits of a call option over shares in the issuer at a fixed price.

Issuers will usually not have to secure the CLNs over their assets to be able to defer payment of the interest and principal under the CLNs to the end of its term, offering cash flow benefits versus traditional borrowing.

Joss Alcraft is a principal at law firm Matthew Arnold & Baldwin.

This article was originally published on 15 July 2009 by Hunter Ruthven.

More on raising early-stage finance  

How to raise pre-seed funding – If you’re a young business that needs finance to grow, it could be time to look into pre-seed funding. Here’s how to do it