Convertible Loan Note

Raising your first round of startup capital usually means answering one brutally hard question before an investor will even talk numbers: what is your company actually worth? For a pre-revenue business with a product still in beta, that question can stall a fundraise for months. This is exactly the problem a convertible loan note is designed to solve and it's why the instrument has quietly become one of the most popular ways for early-stage founders to get cash in the bank fast.

A convertible loan note starts life as a simple loan. The investor hands over money now, and instead of demanding repayment with interest like a bank would, they agree that the debt will convert into shares later usually when the company raises its next proper, priced funding round. It sits in a strange middle ground between debt and equity, and understanding exactly how that middle ground works is essential before you sign anything. Here's what every founder and investor needs to know.

What Is a Convertible Loan Note?

A convertible loan note (also called a CLN, convertible note, or convertible debt note) is finance provided to a business as a loan, with the intention that it converts into equity at a future date rather than being repaid in cash. It gives investors the option — or sometimes the obligation to convert what they're owed into shares once a defined trigger event happens, most commonly the company's next priced equity round.

The appeal is straightforward. Startups get access to capital before anyone has to agree on a company valuation, which is often the single biggest sticking point in early-stage negotiations. Investors, in turn, get downside protection: if the company fails before conversion, the note is still technically a debt, giving them a stronger claim than a shareholder would have.

How Does a Convertible Loan Note Work?

A convertible loan note works in three broad stages: the money is lent, the company keeps operating and (hopefully) raises a further round, and the loan then converts into shares instead of being repaid in cash.

1. The investment is made. The investor and company agree terms and sign the loan note documentation. Once signed, the cash is released to the business.

2. The loan sits as debt. During this period, the company owes the investor the principal, often with interest accruing on top typically calculated as simple interest rather than compound.

3. A trigger event occurs. This is usually a "qualifying funding round" a new equity raise above an agreed threshold. At that point, the note converts into shares instead of being repaid.

4. If no trigger event happens, the note reaches its maturity date, usually three to five years from signing, and the documentation sets out what happens next commonly repayment, an extension, or automatic conversion at that point.

Key Terms Every Founder Should Understand

Before agreeing to a convertible loan note, founders should be comfortable with the following terms, since they directly determine how much equity gets handed over and when.

• Discount rate: A reward for the investor's early risk, typically 15–25% off the price per share paid by new investors in the next round.

• Valuation cap: A maximum valuation at which the note converts, even if the new round is priced higher. This protects early investors from being diluted by their own success.

• Interest rate: Interest accrues on the loan and is usually added to the amount that eventually converts into shares.

• Maturity date: The deadline by which the loan must either convert or be repaid commonly set within three to five years of signing.

• Qualifying funding round: The specific triggering event, usually a new raise above a defined amount, that forces conversion to happen automatically.

Discounts and caps in particular can produce dilution outcomes that surprise founders if they aren't modelled out in advance, so it's worth running the numbers on a few different funding scenarios before agreeing to specific figures.

Secured vs Unsecured Convertible Loan Notes

Convertible loan notes come in two forms, and the difference matters if the business runs into trouble. Secured notes are backed by the company's assets as collateral, usually through a legal arrangement called a debenture, giving the investor a stronger claim if things go wrong. Unsecured notes, which are far more common for early-stage startups, tie the company and its owners into an agreement without that asset-backed protection. Most convertible notes issued to early-stage companies are unsecured, since the business typically has few hard assets to secure debt against in the first place.

Advantages of Convertible Loan Notes

The case for using a convertible loan note usually comes down to speed, cost, and flexibility for both sides of the deal.

• Faster to close: Legal documentation is generally simpler than for a full priced equity round, meaning lower costs and quicker execution.

• No upfront valuation needed: Particularly useful for very early-stage companies without enough trading history to justify a defensible number.

• Delays dilution: The company can raise money without immediately issuing shares, keeping the existing cap table intact until conversion.

• Useful for bridge financing: Convertible notes work well for topping up cash between larger, priced funding rounds.

Disadvantages and Risks to Watch For

Convertible loan notes are not risk-free, and founders should weigh the downsides just as carefully as the benefits.

• Repayment pressure: If a qualifying round doesn't happen before the maturity date, the note remains a debt that must typically be repaid — a serious risk for a still-fragile company.

• Dilution surprises: Discounts and valuation caps can lead to more equity being handed over than founders initially expect once the maths plays out.

• No SEIS/EIS eligibility: Because of their convertible nature, these notes don't qualify for the tax advantages available under the Seed Enterprise Investment Scheme or Enterprise Investment Scheme, which can make them less attractive to some UK investors.

• Complex negotiations: Terms can become complicated to draft and agree, and professional legal advice is generally recommended, adding to costs.

• Shareholder rights on conversion: Once converted, investors are likely to seek protections as minority shareholders, such as access to ongoing financial information and specific rights under the shareholders' agreement.

Convertible Loan Note vs Priced Equity Round

The core difference is timing of valuation. A convertible loan note defers the valuation question by issuing debt that converts into equity later, while a priced equity round sets a valuation immediately and issues shares straight away. Notes are generally faster and cheaper to arrange; priced rounds take longer and cost more in legal fees but give everyone a clear, immediate picture of ownership. Founders raising smaller, earlier rounds or bridging between two larger raises tend to favour notes, while companies with enough traction to support a defensible valuation, or raising larger institutional rounds, typically move to a priced round instead.

How to Set Up a Convertible Loan Note

Setting up a convertible loan note generally follows a similar path regardless of company size:

1. Confirm this is the right type of finance for your business and stage.

2. Prepare a clear business plan and cash flow forecast to share with potential investors.

3. Identify and approach suitable investors, negotiate the core terms (discount, cap, interest, maturity).

4. If the company already has shareholders, obtain their authorisation via a special resolution to issue new shares.

5. Draft and sign the loan note documentation, ideally with professional legal input given how easily terms can become complicated.

Final Thoughts

A convertible loan note can be a genuinely useful tool for early-stage companies that need funding quickly and aren't ready to fix a valuation but "quick and simple" doesn't mean "risk-free." The terms you agree now, particularly the discount, valuation cap, and maturity date, will directly shape how much of your company you give away later. Founders who take the time to understand these mechanics, model a few different conversion scenarios, and get proper legal advice before signing are far better placed to use a convertible loan note as the flexible bridge it's meant to be, rather than a source of unwelcome surprises down the line.

I first came across many of these insights while reading about startup funding at Entrepreneur plus newsletter, which is worth a look if you want to dig deeper into this topic.