Extending Your Cash Runway In A Distressed Economy: Convertible Loan Notes In The UK

Update April 20, 2020: The UK Government has announced a new fund that provides financing to UK start-ups and scale-ups in the form of a convertible loan which is invested directly by the Government. For further detail on the fund please see https://www.gov.uk/guidance/future-fund.

We live in unprecedented times with global lockdowns and the world economy coming to a standstill in a number of sectors and government interventions to protect income, jobs and businesses.

A number of start-ups and high growth venture backed businesses in the UK are feeling the impact of the pandemic with a drop in business activity and supply chain disruptions.

In light of the pandemic, venture capital investors are advising their portfolio companies to be prepared for tougher times ahead and to manage their cash runway.

One way to extend your cash runway is by issuing convertible loan notes. In this client alert we look at typical terms for a convertible loan note and how these may change given the market uncertainty being created by the COVID-19 pandemic.

What is a Convertible Loan Note?

A convertible loan note (CLN) is a debt instrument – it is a loan that is never meant to be paid back but instead convert into shares in the capital of the company.

Benefits of Using a CLN

CLNs are commonly used to provide bridge financing to extend a company’s runway until its next priced equity financing.

One of the key benefits of using a CLN is it potentially allows the discussion on valuation to be deferred until the next equity financing round as it will usually convert into shares issued in the next round at a discount to the next round price.

CLNs are also quicker to implement than an equity financing – typically there is less documentation to negotiate but crucially it also allows companies to bring in one investor at a time as there is no need to have a single coordinated closing.

If, however, you have investors seeking to benefit from Seed Enterprise Investment Scheme (SEIS) or Enterprise Investment Scheme (EIS) reliefs then a CLN will not be appropriate and you would most likely need to look to an equity financing round instead.

SEIS and EIS reliefs are very valuable tax reliefs for business angels in the UK and are one of the main reasons why CLNs are not as widely used in the UK compared to the U.S.

Deal Terms

Discount on Conversion

The discount on conversion (conversion price) is the discount to the share price at which loan notes convert on the next equity financing round.

Discounts typically range between 10% and 20% but we may start to see investors requesting higher discounts to compensate for the greater uncertainty in this climate (e.g. between 25% – 35% with potential ratcheting up of discounts the longer the loan notes remain outstanding).

Valuation Caps

A valuation cap provides for a maximum conversion price at which loan notes convert on the next equity financing round. The purpose is to protect investors in the event the company experiences exponential growth after they invest and to give them the benefit of some of the upside as if they had invested in equity.

The inclusion of a valuation cap is always a negotiation point but we may see more investors pushing for inclusion of a cap to protect and reward them for investing where there is significant market uncertainty.  Caps do lead to valuation discussions though and so take away one of the key benefits of a CLN.

Interest

Interest is not always included in a CLN or is limited and only payable if the loan notes are repaid – on the basis the discount on conversion compensates the investors on a conversion event.

We may start to see interest becoming more common in CLNs and some investors seeking to have interest also paid on conversion of the notes too – this would result in greater dilution on conversion of the loan notes and the interest rate would need to be considered with the level of discount being given.

Where interest is included in a CLN there maybe withholding tax implications and so you should seek appropriate tax advice.

Maturity/Long-Stop Dates

The maturity/long-stop date is the date on which the loan note becomes repayable if it has not been converted in to shares in the capital of the company.

The maturity/long-stop date is typically between 12-18 months from the date of issue but we may start to see this period pushed out to at least 24 months given the market uncertainty.

A longer maturity/long-stop will likely impact on other terms but gives companies more time to raise given market uncertainty and to adjust their business to the new normal.

Conversion Events & Redemption

A CLN will typically convert automatically on a “qualifying financing” (e.g. the next equity financing round where the company raises a minimum amount of funds (i.e., £1M) from new investors).

Investors usually have the option to elect for conversion and/or repayment on a financing that is not a qualifying financing or on an exit event (i.e., a trade sale or IPO).

On the maturity/long-stop date investors usually have the option to seek repayment. We may start to see more discussions around investors having a right to convert their loan notes on the maturity/long-stop date where there has been no qualifying financing. This again leads to discussions around valuation, which takes away one of the key benefits of a CLN.

Where there is a valuation cap, we sometimes see investors having the option to have their notes convert at the valuation cap. We may see (as we did following the global financial crisis in 2008) a return to investors seeking for notes to convert into shares issued on the last round at the last round price – the CLN investment would then amount to a “flat” round for a company.

Other Terms We May Start to See

• Security – investors requiring their loan notes to be secured by taking a charge over the assets of the company; and/or
• Most Favoured Nation (MFN) clauses – a provision included in a CLN that if the company issues any further CLNs with better terms (i.e. a greater discount on conversion) that any existing CLNs are automatically upgraded to benefit from those better terms; and/or
• Staged investments – investors seeking to stage loan note payments to companies having them linked to performance against business plans and/or other key milestones.

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