VC Focus | Why VCs and companies use convertible loan notes and bridging rounds in the UK

Raising venture capital finance is challenging at the best of times and most venture capital backed companies require several rounds of equity financing before they reach sustained profitability or exit.

This journey is sometimes called “following the funding alphabet”, which refers to doing a “series A round”, followed by a “series B” and so on. To further confuse things, there are also earlier rounds often labelled “seed” or “pre-series A” rounds. Where the journey starts is still pretty clear and what it is called is just semantics.

Somewhere along this journey (usually at the beginning but sometimes in-between seed and series A funding), the company might need bridging debt to start trading or to stay afloat. We also see bridging debt provided at later stages to keep a company trading pending a larger franchise or an exit, whether that be a sale or IPO. This type of debt funding is often provided in the form of a convertible loan or, in the UK, through convertible loan notes.

What are convertible loans or loan notes?

A convertible loan allows the investor to convert its loan into equity (that is, shares) in the borrowing company on pre-agreed terms. Other than this, they are just normal commercial loans.

Convertible loan notes are a more sophisticated form of convertible loan, as they allow the company to accept the same loan from multiple investors, at the same time and on the same terms, by issuing each investor with a loan note from one governing agreement.

Loan notes also allow multiple investors to regulate how they manage their respective parts of the loan between them, as a group, usually by some sort of majority rule that will bind everyone. This can be very useful when there are lots of parties involved (for example, groups of venture funds or business angels).

Convertible loan notes tend to be the form of instrument used more frequently in the UK. However, the terms, advantages and disadvantages are equally applicable to straightforward convertible loan agreements.

What are the usual terms?

The right to convert into equity is usually triggered by a certain future event or events, for example, completion of the company’s next equity funding round (series A or series B, and so on). It might also be an exit (trade sale or IPO).

Sometimes the decision to convert is at the investor’s option alone (this can be done by majority rule if there are lots of investors). The other alternative is for an investor, or investor majority, to ask for repayment of the loan, along with any accrued interest and pre-agreed redemption premium.

Often companies will push for convertible loan notes to convert into equity automatically. This often happens on further equity funding rounds or on exit, provided the event is of a certain size and valuation. This provides certainty for the company and new investors that the company will be debt-free going into the next equity round or exit and helps to get the transaction done more smoothly.

No matter what the conversion trigger, it is quite common for conversion to take place at a discount to the share price set by the next equity round or exit. A discount in the range of 10% to 30% is normal. This is done to reward (and induce) the investor to provide the bridging loan in the first place, often at a more risky/pivotal moment for the company.

If the conversion trigger is a further equity funding round, it is normal for the investor to convert the loan into the most senior class of share being issued by the company on that round (so they are in the same position as other investors).

Investors sometimes also have the right to convert into an existing class of share at a pre-agreed price, usually as an agreed "longstop date", just in case a further funding round (or an exit) does not happen.

Sometimes convertible loan notes will carry interest in addition to the conversion discount. However, it is rare for this interest to be paid (as most VC-backed companies cannot afford to pay it). Instead, any interest is “rolled up” and then added to the amount of the loan to be repaid or converted on the next equity funding round, as if it were capital.

Less commonly, convertible loan notes also have a redemption premium, so that on repayment, the company has to pay back the loan and the redemption premium. The premium can be anything, but where there is redemption premium it is often one times the amount of the loan. It can therefore be an expensive form of finance for the company if the loan is not converted into equity.

Redemption premiums are only really used when the risk profile of the investment is high. This mostly happens in between later stage funding rounds, when the company has not performed as expected and is in danger of not being able to deliver its business plan.

Convertible loan notes can also be secured against the assets of the company, although this is less common, due to the additional complexity and negotiation time this can result in.

What are the advantages of convertible loan notes?

Convertible loan notes are fantastically flexible, so appeal to both companies and investors, as they can be tailored to suit particular needs. They are also quite straightforward to put in place quickly, which is just what is needed when cash flow is squeezed.

Convertible loan notes are a good way for companies to raise money before their first round of equity finance (seed or series A), as negotiations around the valuation of the business can be postponed until the full equity funding round or until an important commercial milestone has been achieved (such as a successful beta software test for digital business companies). This means a company can avoid unnecessary dilution by giving away too much of its equity too early.

Some convertible loan notes can be lower risk for investors than equity, as debt will always rank before equity in the event of insolvency. In reality this is only useful if the company has assets, which is unlikely for most early stage businesses if they become insolvent.

What are the disadvantages?

Several generous tax reliefs for investors (such as Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS)) will not be available. This is a complicated area, but investors can only get EIS/ SEIS when they invest their money for equity. Loans do not qualify, even if/when they convert into equity. This point is often missed by individual investors looking for EIS or SEIS relief.

An alternative approach that can be used where the investors hope to obtain EIS/ SEIS relief in the use of an "advance subscription agreement" (ASA) instead. Unlike convertible loan notes, which are debt and in certain circumstances repayable, ASAs are advance subscriptions for shares, where in all circumstances the subscription monies will be converted into shares (on a next equity finance round, or longstop date) and cannot be cash repaid. This is a higher risk position for investors, but in certain circumstances such ASA arrangements can qualify for EIS/SEIS – although this will depend on the terms of the ASA (for example, maximum time period for conversion to equity) so companies and investors should seek specialist advice.

Bridging loans can sometimes also be taxed as deep discounted bonds if they carry a high interest rate and/or a redemption premium. This can create income tax charges for personal investors (or personal individuals in private equity funds) on conversion. This is a complicated area and specialist advice is needed.

The key point is that companies and investors should get tax advice before using bridging loans, especially those with redemption premiums.

In some cases, convertible loan notes can put off new investors from participating in a proper equity funding round, as the new investor might not like the discount existing investors are due to receive on conversion. New investors are also likely to insist that all bridging loans are converted into equity, as they will be sensitive to any part of their new investment being used to repay loans from existing investors.

We recommend taking advice early if you are thinking about using convertible loan notes as part of your fundraising and/or lending strategy to avoid problems further down the line.

Other options

As mentioned above, an alternative form of bridging financing that is sometimes used is an ASA. These tend to be more company-friendly than convertible loan notes, so are often used where the investor is seeking to benefit from a preferential tax position, such as EIS/SEIS (subject to the health warnings flagged above). However, ASAs are also sometimes used more widely – perhaps where those participating are all existing shareholders and so comfortable with the risks, or are very keen to participate in the bridging round to get their "foot in the door".

You may also see or hear investors talking about using "SAFEs" for raising funds before (or in between) full equity fundraisings. A SAFE is shorthand for Simple Agreement for Future Equity and was first introduced by the US Start-up accelerator Y Combinator nearly 10 years ago. SAFEs are something of a "halfway house" between a convertible loan note and an ASA, as a SAFE usually has no longstop date (until a conversion event occurs, SAFEs remain outstanding) nor any interest rate, however they usually do provide for cash repayment options in exit or insolvency scenarios. The original form of SAFEs are governed by US law and use language that assumes that the investee company is incorporated in the US, so are not fit for purpose for use for a UK incorporated company in this form. However, it is possible (with appropriate legal advice) to adapt the forms of SAFE to be an English law document, which sometimes UK companies will use to secure investment from US investors in a form of instrument that they are more familiar with.

Osborne Clarke has a market leading venture and growth capital practice across Europe, supporting investors across sectors including financial services, media and communications, life sciences and healthcare and real estate and infrastructure. If you have queries on any of the issues covered in this note please connect with one of our experts.