Having the faith to convert
Understanding the Convertible Loan Note
Venture Capital investors are equity investors. Generally, they accept the risks inherent in investing permanent capital into loss making businesses in return for a share of the upside generated when a company makes a successful exit. Within the limited structuring options open to manage these risks, the Convertible Loan Note (or “CLN” for short) offers some interesting opportunities for both investor and entrepreneur, and is increasingly used throughout the growth curve of a company. It is important therefore to understand the basic features of the instrument, and the implications of using them for both investor and entrepreneur.
Outline of a CLN
A CLN is exactly what it says on the tin — a short-term loan designed to convert to equity under certain predefined conditions. It is therefore comprised principally of debt-like terms, and terms that govern how and when the note will convert into equity.
We most commonly associate debt instruments with a coupon, but a coupon is not always present in a CLN as it is not the primary purpose of the investment. Where a coupon is applied it will normally be in the range of 8–12%, i.e. well below the cost of capital for a loss-making firm and will almost certainly be rolled up on the Balance Sheet. The object of this debt instrument is to act as much like equity as possible whilst maintaining some degree of optionality for the investor.
As with any loan, the CLN will have a maturity date. The maturity of the CLN will be the point in time by which an event is expected to have occurred that will cause the conversion of the debt to equity. Typically CLNs have a maturity between 12 and 24 months.
CLN notes will usually convert into the highest class of shares at the point of conversion i.e. the share class with the highest preference on any return of capital to shareholders. Usually conversion is triggered by a new round of equity where the CLNs will automatically convert into the newly issued share class. Terms governing this automatic conversion will often specify a minimum amount of capital to be raised to ensure the company has sufficient funds to execute its business plan. In the event of an exit event during the term of the loan, the notes will usually convert into the highest existing share class prior to calculation of equity returns.
In return for the risk taken by the note holders in bridging the company’s finances, the CLN will specify that when the conversion of debt to equity occurs, it does so at an advantaged, or discounted price. Typical discounts are up to 20% and often increment during the term of the loan as a reflection of the increased risk to note holders. Discounts over 25% would be unpalatable for investors in the conversion round and are therefore never validly used, although it is worth noting that any attached coupon is effectively a discount by other means.
Despite specifying a discount to a new future round, CLN investors want to avoid paying excessively for any major value uplift from loan to conversion that their capital has essentially enabled. To address this issue CLNs will therefore often define a highest price that will be paid, or a price “cap” to the conversion. Equally the CLN is likely to include a minimum or “floor” price, the lowest price at which the notes would convert usually at maturity if a qualifying round of finance has not been raised. This price will often be relatively punitive (e.g. at or below the last round price) to ensure company and investor incentives are aligned on the expected timelines for further funding or exit.
Not just delayed equity
CLNs will always carry a clause requiring repayment of the loan in the event of certain events of default by the company and perhaps an option for the investor to have the loan repaid in the event of a change of control. Sometimes there will also be an option for the investor to call the loan plus any interest at the point of maturity if a qualifying round of finance has not been raised.
Common wisdom is for an entrepreneur to avoid the redemption clause on maturity, but in reality it carries little weight. For starters, if the clause is capable of being triggered then the company probably has no funds. Forced to its conclusion, the clause is therefore simply stating what the loan already has i.e. a senior claim over the assets of the company in any administration. Secondly, the structure of most VC investors is as a GP/LP fund. This structure requires that any redemptions to the fund be paid straight back to the LPs. Capital paid back at par to the fund shareholders will have a punitive effect on fund performance (see here for a demonstration of fund maths), and it is likely that in all but the most dire situations the investor will provide some additional capital to further enhance the opportunities for a later successful fundraising or exit and that at such point the CLN would be converted (albeit at a floor valuation).
Purpose
Most often a CLN is used by investors to fund companies where there is an inability or an unwillingness to set a new price for the equity. This may be where the funding is required to bridge a period of time, perhaps to allow the company to prove out new products, markets or key KPIs in order to further the company’s valuation prior to raising a larger round, or perhaps to bridge a smaller funding gap to an exit opportunity. Often this helps to optimise the cost of the new equity by minimising the dilution, and therefore CLNs are more commonly written by existing equity investors in a company.
For example, consider a company whose plan requires a further £20m of capital to cash positivity. The company currently has £10m in run rate revenue, is growing 100% year-on-year and is valued at 8x run rate revenue. If it raised the full £20m of equity now, investors would suffer a 20% dilution from the new capital (£20m/(£80m + £20m)). If instead it raised £5m in a CLN with a 20% discount, and the remaining £15m +6 months later when the revenue run rate has grown to £14m, then the overall dilution for new capital would be limited to 15.8%. At the same time, the CLN investors would purchase their equity at broadly similar price levels (£80m in the first case, and 80% x £113m = c £90m in the second).
Illustration: Later funding enabled by CLN
From the investor perspective, the mechanics of a CLN conversion mean that investors are given an immediate uplift in valuation at a price level that is independently set by a third-party investor. This allows professional investors to demonstrate price improvement in the Net Asset Value of their portfolio since as a loan the notes will be held at cost until conversion. This is an attractive feature for most portfolio managers.
Postscript: Pay attention to the conversion
Strictly speaking at the point of completion of the future funding round the CLN is held on the company’s balance sheet as a debt. Technically therefore the value of the CLN should be subtracted from any Term Sheet Enterprise Valuation on the business before calculating the fully diluted price per share from which any discount is to be calculated. If the CLN converts in the round without first subtracting its value, the incoming investor is effectively being diluted by the discount granted by existing investors. Implicitly the valuation has been interpreted as an equity and not an enterprise valuation. Investors may be more focused on this than entrepreneurs, but it is interpreted with surprising ambiguity in most transactions.
Martyn Holman
@holmanma
