Although the situation is still developing, it does appear that the pandemic is making it more difficult to secure equity financing terms on a valuation that is acceptable to founders and existing shareholders. As a result we are starting to see these “interim” financing methods being used more widely and on a more protracted basis.  This guide sets out answers to the most frequently asked questions we receive on this subject.

What is a convertible loan note?

A convertible loan note is a debt, with a mechanism for the principal amount (plus, usually, accrued interest) to convert into equity in certain circumstances.  Conversion most commonly occurs on a “qualified financing” (i.e. a subsequent equity investment round above a specified level), but would also take place on an event of default or on a sale, change of control or liquidation of the business.

Convertible loan notes may be secured over the assets of the business but this has been rare as note investors tend to be venture capitalists (who do not see themselves as institutional lenders) and growth companies don’t tend to have a lot of assets to secure.  It remains to be seen whether we will begin to see more of a trend towards this given current economic conditions.

Terms are, and have always been, subject to negotiation but the following provisions are commonly included:

Interest: convertible notes often have no or low interest rates, or where interest does accrue it is rolled up and converted into shares along with the principal amount (often called ‘capitalised interest’).In the current climate we are starting to see interest, sometimes at rates as high as 10%, payable in cash (either at maturity on a rolled up basis or at regular intervals) with only principal amounts being converted to shares.

• Discount on conversion: convertible notes will generally convert at a discounted price per share to that being paid by new investors participating in the “qualified financing”.We are seeing investors try to push these rates higher.

• Valuation cap: investors may demand a cap on valuation, increasingly in addition to (and not as an alternative to) a discount on conversion.The effect of the cap is to fix a maximum conversion price per share for the convertible loan note holders, i.e. if the actual valuation on a “qualified financing” is higher than the cap, for the purposes of calculating the convertible loan note holders’ conversion price, the valuation will be deemed to be equal to the cap. The cap may be set by reference to the pre or post money valuation (i.e. disregarding or including the new money being invested as part of the “qualified financing”) with the former leading to the most significant potential reductions in share price.Another approach is to specify that on conversion the convertible loan note holders will be entitled to a fixed percentage shareholding.

• Long-stop/maturity date: “equity-based” convertible loan notes convert automatically to shares at maturity whereas “debt-based” convertible loan notes will, if they have not already converted under the terms of the instrument, need to be redeemed by the company in cash.For automatic conversion to occur, the price per share will need to be prescribed (and this is typically the price of the last institutional round).

What is an advance subscription agreement (ASA)?

Under an ASA, an investor agrees to make an advance payment of subscription monies for shares in a company.  These shares will be issued at some point in the future, on a “qualifying financing”, sale or liquidation as with convertible notes, or on a long-stop date.  An ASA is not a debt; it does not generate interest, and it can never become repayable in cash.

Much like convertible loan notes, the shares will usually be issued at a discount and/or an investor will often want to agree a cap on valuation (see above).  Unlike convertible loan notes, an ASA can be used by UK-resident investors wishing to make use of tax reliefs under the Seed Enterprise Investment Scheme (SEIS) and/or Enterprise Investment Scheme (EIS) provided that: (1) the shares, when issued, will be ordinary shares; and (2) the long-stop date is no more than six months following the date of the ASA.  Legal advice should always be sought if an investor is looking to make use of the scheme(s) to ensure that the ASA is structured appropriately and in accordance with HMRC guidance.

Are there ‘standard forms’ available for these types of documents?

You may have come across acronyms such as SAFE, eFAST and KISS.  These are precedent documents available online for those seeking simple forms equivalent to ASAs or convertible loan note instruments.  These, and other similar forms of agreement, are generally drafted in an investor-friendly way, and are often geared for US companies – whose shares work differently to those of English companies.  Therefore, it is important for companies to take legal advice before using these documents or agreeing to the underlying commercial terms set out in them.

What are the pros and cons of convertible loan notes and/or ASAs?

Pros:

• Negotiating and documenting a straight equity investment can be complex, time-consuming and costly from a legal perspective.Convertible loan note instruments and ASAs tend to be shorter, simpler documents with fewer commercial issues to agree and some of the more detailed negotiation (particularly around valuation) can be put off until a later date when more information is available and the company may be in a stronger position.This means the money can flow a lot quicker.

• Convertible loan notes can be attractive given their status as debt prior to conversion.This gives the convertible loan note holders priority over shareholders on a liquidation and this type of investment can therefore be viewed as being less risky if the company has a substantial asset base.Conversely, an ASA is purely an agreement for equity so does not afford investors such protection.

• The consent of the convertible loan note holders will generally be needed before the company can take on any other debt, and such debt is commonly required to be subordinated to the loan notes (putting the convertible loan note holders in a better position than other unsecured creditors).Again, this can make convertible loan notes an appealing option from a risk perspective.

• If structured correctly, UK-resident investors under an ASA can benefit from SEIS and/or EIS relief.This is not the case for convertible loan note holders.

Cons:

• If an investor requires a cap on valuation this needs to be negotiated and documented in the same way as a valuation on an equity round.Equally, if shares are to be issued automatically on a long stop date then the price per share (or a mechanism for determining it) will need to be fixed.This means that some of the detailed negotiation you may have hoped to defer will need to take place now, detracting from the time and cost savings.Predicting and agreeing future valuation is problematic at the best of times, let alone in the current economic circumstances.

• A discount on conversion and/or a cap on valuation can have negative consequences for the company and its existing shareholders:

• If ASA/note investors are entitled to a large discount (either through a discount rate or a cap) and their shares will make up a high proportion of the new shares to be issued, this can substantially depress the actual amount of new money that will result from the “qualified financing” and be off-putting for potential new investors.
• An artificial cap on valuation may drive down the actual valuation on future rounds as new investors will not want to invest at a significantly higher price.

• If valuation on the “qualified financing” turns out to be far higher than expected and the investors do not have a cap, the founders will come under pressure from the ASA/note investors to reduce valuation to maintain the ASA/note investors’ target percentage.

• The dilution of existing shareholdings may be more extensive. New investors may call for non-founder shareholders to bear the brunt of this in order to preserve founder shareholdings at an appropriate level (for incentivisation purposes) which may cause additional discontent among the existing shareholder base.

For the above reasons, managing the dynamics between ASA/note investors, next round equity investors, and founders can prove very complicated and it is not unusual to see incoming investors seeking to pressure ASA/note investors into renegotiating their terms.

• ASA/note investors will generally receive the same rights as equity investors in the “qualified financing”, which may be more extensive than they would have received if they had made a straight equity investment of the same size.

• Conversion of “equity-based” convertible notes and ASAs at the end of their terms will generally be at low valuations; as the timetable runs down, founders will become much more likely to take investment on bad terms.

What other possible financing options are there?

As mentioned above, convertible loan notes and/or ASAs can be an alternative to equity financing which may be hard to agree at present (although companies that do issue convertible loan notes with particularly high interest rates, or enter into ASAs with short maturity periods, may find themselves seeking a “qualified financing” in fairly short order in any event).

Traditional borrowing may be an alternative for some growth companies, though lenders will almost certainly also place more restrictions on the operation of the business. In the current climate they may also seek security over assets, which may limit the availability of this type of finance for earlier-stage businesses.

Another option is of course to look to existing shareholders to invest further, through a priced equity round. You might not get any better valuation from the “home team”, but in general you should be able to take investment on the same or similar terms as you are already operating under – so taking the speed/simplicity benefits of the convertible/ASA structure but avoiding many of the drawbacks.