Convertible loan notes and bridging rounds: what are they and why do VCs and companies use them?

Written on 5 May 2015

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 profitably 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, in recent years, there has been an explosion of “seed” or “pre-series A” rounds. In our opinion, where the journey starts is still pretty clear and what you call it 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 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.

In this blog post, Robert Wood and Mathias Loertscher look at convertible loans and loan notes and their particular use in VC-backed companies.

1. What are convertible loans or loan notes?

A convertible loan allows the investor to convert its loan into equity (i.e. shares or stock) 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).

In this post, we mainly refer to convertible loan notes as this tends to be the form of instrument used more frequently in the UK. However, the terms, advantages and disadvantages are equally applicable to straight-forward convertible loan agreements.

2. 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 etc.). It might also be an exit (trade sale or IPO).

The decision to convert is usually the investor’s 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.

Some convertible loan notes can convert into equity automatically. We often see this happening 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, just in case a further funding round (or an exit) does not happen. This is rarer and, in our opinion, less logical.

Most convertible loan notes will carry interest at a rate of around 8-10% per annum. However, it is rare for this interest to be paid (as most VC-backed companies can’t afford to pay it). Instead the 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.

Some 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 is usually 1x 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. Security is rare for start-ups, but is more common at later stages of the growth cycle, when the company has created valuable assets (e.g. intellectual property).

3. What are the advantages of convertible loan notes and why are they used on bridging rounds?

As you can see from above, 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 straight-forward to put in place quickly, which is just what’s needed when cash flow is squeezed.

Investors usually have the freedom to choose between repayment or conversion and, if they choose conversion, they get the benefit of a healthy discount to the share price on the next equity round.

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 (e.g. a successful beta software test for tech, media and comms 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, especially if secured, 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.

4. 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.

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. Again this is a complicated area and cannot be given justice in this blog post. The key point to get across is that companies and investors should get tax advice before using bridging loans, especially those with redemption premiums.

At a commercial level, bridging loans can reduce the momentum or urgency to complete a proper equity funding round. They can also lead to drip fed funding support that is not always healthy for either side, and to short-term decisions on capital expenditure. We have seen situations where companies have had several bridging loans before their next equity funding round just to stay afloat, which has diverted a lot of management time away from actually running and building the business.

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.