Here at SOSV we invest into 200 companies per annum. These investments take a variety of different formats depending on the location of the company, the stage of the investment, the amount of money being raised, and a number of other relevant factors. A very popular format for an early stage company to raise finance, especially in the US, is via convertible debt.

I see many forms of these instruments per annum with different quirks and clauses that are either suited to the investee company, or demanded by their Investors. So, let’s talk about debt….

Convertible Loan Note (“CLN”) is essentially a form of debt which has the ability to either be repaid or be converted to equity, generally a class of Preferred Stock, at some future date in accordance with the terms of the Note itself.

The CLN is commonly used in financing rounds when the valuation of the company is unknown or uncertain and dependent on a number of factors that are going to happen in the next 12–24 months. The Note can reward investors who come on board early without causing valuation issues for the startup (however, see below in respect of the Valuation Cap).

This form of financing provides for a right to equity in the future, and because of this, the CLN generally does not grant the CLN holder voting or information rights, board seat, or some of the important control terms that you would often see in an equity financing. This can be important to a startup company as the founders may have many plans that they feel would be better executed without interference from an angel or early stage investor. However, as a debt, the CLN is seen as senior to equity in a liquidation event and therefore has the benefit of superior downside protection on a return. CLNs are usually less complicated (and as a result less costly) for startups and can generally be closed faster than an equity financing round.

The general intention of the parties to the CLN is that the Note will in fact convert to equity and not simply be repaid with interest or stay outstanding indefinitely. The primary triggers for the conversion of a Note are generally the “Maturity”, an “Exit”, and a “Qualified Financing”. The actual number of Preferred Shares the Note will convert into will have to be calculated in accordance with the agreed terms of the Note.

The CLN will have a stated Maturity Date at which time, or any time thereafter, the Note-holder will look to have the Note repaid (which in general, rarely happens) or will convert to equity on agreed terms. If the startup is cash strapped at the Maturity Date with no sign of a capital raise there may be limited options available — negotiate with the Note-holder to extend the Maturity Date, convert the Notes to common stock at a pre-agreed value (whether it is at the option of the Note-holder or the company), or simply try to repay the Note from positive cash flow.

The CLN will generally contain a clause allowing for automatic conversion of the debt when the startup achieves a Qualified Financing. Qualified Financing is generally an equity financing round by the startup to raise capital from investors at a pre-determined level, generally around $1m, for “Qualified Securities”. Qualified Securities are usually the class of share in a qualifying equity round (normally preferred stock), for example a Series Seed round. Once the Qualified Financing level is achieved by the startup, the CLN will automatically convert to the Qualified Securities.

The amount of Qualified Securities that the CLN can convert into will depend on the price of the next round and two key elements — the “Discount Rate” and the “Valuation Cap”. Both of these clauses give the Note-holder the benefit of being first to invest i.e. a maximum price that will be paid (Valuation Cap) or a discount on the price the next investor is paying (Discount Rate). Without the Discount Rate or the Valuation Cap, the Note would essentially convert into the Qualified Securities at the same price as the equity issued in the next round. The Discount and the Valuation Cap are provisions that attempt to remedy this.

  • Discount Rate: The discount rate acknowledges that the Note-holder has taken on additional risk in investing at such an early stage in the startup. The Note-holder gets a level of protection on the basis that the Note-holder will have the entitlement to a discount against the future stated value of the company at the time of conversion. The discount rate can be between 15%-25%, and is generally 20%.
  • Valuation Cap: The valuation cap (the “Cap”) again aims to acknowledge the risk taken by the early stage Note-holder as an investor in your company. The valuation cap sets the maximum price into which the loan will convert to equity in the startup — essentially protecting the Note-holder by setting a limit on the conversion price of the Note so that the Note-holder is guaranteed a minimum number of Qualified Securities if the subsequent priced equity round is above the Valuation Cap level. If the next round is at a valuation level below the actual Valuation Cap, then the Cap calculation may not be relevant. The Note-holder will generally want to keep the Cap low so that the Note-holder can share in a jump in value in the startup and, as a result, at the time of conversion the investment will convert into the maximum amount of equity. The Cap is generally consistent with the what the Founders consider the valuation of their startup is at the time of the CLN. Remember, the Cap is the maximum price that the Note can convert. Founders should remember that if the Note converts at the Cap this is generally a good sign as the actual valuation of the company at the time of conversion is probably greater than the Cap.

The CLN will convert at either the discount rate or the valuation cap, whichever results in the best (i.e. lowest) price for the investor.

The Note will generally also contain a provision to deal with a sale, merger, or consolidation (an “Extraordinary Event”). In such case the Note-holder could have the right to the greater of (i) a stated multiple of the Note (i.e. two times (2x) the Note plus all accrued interest) or (ii) the amount the Note-holder would have received if the Note had actually converted to common stock immediately prior to the Extraordinary Event.

In addition, the Note may contain “Voluntary Conversion” provisions whereby the Note, and any accrued interest, may convert at the option of the Note-holder, or if there are several Note-holders, the holders of a majority-in-interest of the outstanding principal amount of the Notes (the “Majority Holders”) on the Maturity Date, (or possibly at the option of the company), into shares of common stock. The Maturity Date of a Note is generally 12 to 24 months after closing (and generally Notes in the same round will mature on the same date, instead of on a rolling basis so that the prospect of new money being used to pay off earlier Notes is avoided).

The Note will generally also include a “Prepayment” provisions whereby the Notes may be prepaid in advance of the Maturity Date only on the express, prior written consent of the Note-holder. As discussed above, the general intention of the parties to the CLN is that the Note (which is generally unsecured and with no other recourse for the Note-holder) will convert to equity and not simply be repaid with interest. An exception to this general rule is a situation where the startup may be acquired before the Maturity Date. In such a situation, the “Change of Control” provisions within the Note will generally apply (allowing for repayment or a mechanism for conversion to common stock).

CLNs will also carry a nominal “Interest”, generally at a fixed rate. Interest rates can vary from 1–15% and interest will accrue on the Note. At the time of conversion of the CLN, the total amount of the principal and the interest will convert into equity.

Investors like CLNs as they limit the maximum price that their money will convert to equity at via the capped value. It offers them a discount on the price that the next investor will pay, it could generate a return of some sort based on the interest, and it also has the same protection as debt if there are liquidity problems in the company (meaning they will be repaid before the stockholders).

Startups like CLNs as they enable them to raise money without focusing greatly on the valuation debate. It sets them a capped value to out-perform, it can be done relatively quickly, and it can be done at minimal legal cost to a cash starved startup.

One major concern for a company raising monies via a CLN is to avoid stacking many convertible debt instruments on top of each other, especially with a variety of different capped values. In the event of the company under-performing or raising an equity financing at a pre-money valuation of less than the capped values, then any CLNs with a discount applicable are going to have a huge impact on the capitalization table. I have seen situations whereby founders go from 80–90% equity holdings to 25–40% post a relatively small equity financing that has become a qualified financing and converted a number of CLNs into equity as part of the financing round.

At SOSV we have developed a new type of CLN called a SAFER. This includes a “trigger” so that if a company has a CLN financing round and raises more than expected, or a significant amount of money in a round, then the round automatically becomes a “priced round” i.e. an equity financing as opposed to debt. The advantage of this is that it locks down the price paid per share and gives certainty to the founders on the dilution effect applicable for the monies raised. It is recommend that founders consider such an approach if they are raising significant amounts of finance.

The phrase “generally” tends to appear frequently in this article. That is because each CLN needs to be tailored to properly reflect the specific agreed terms of the financing — a “one size fits all” approach could cost founders in the long run!

A template CLN is available for SOSV Founders, from the Library tab within the SOSV Portal.

Remember — this article is intended for guidance only and is an overview of the headline terms in a CLN. Founders are recommended to obtain independent legal advice for your CLN round.