Convertible loan notes: debt today can become equity at the next funding round

A convertible loan note starts as debt but can convert into shares when an agreed trigger occurs, often the next equity funding round. Early-stage companies use CLNs to raise money quickly before fixing a full company valuation, but founders need to understand the future dilution and what happens if the expected funding event never arrives.

The investor advances a loan with a future conversion mechanism

The British Business Bank describes convertible loan notes as debt funding that gives the investor the right or obligation, depending on the terms, to convert the loan into equity when specified events occur.

The company receives cash now without completing a full priced equity round. Until conversion, the legal instrument remains debt under the agreement.

Define exactly what triggers conversion

Common trigger events include a qualifying fundraising round, acquisition, IPO or maturity. The agreement should state the minimum size and type of financing that counts as a qualifying round.

If the trigger is vague, founders and investors can disagree about whether a small bridge round forces conversion. The document should make the treatment mechanical rather than negotiable under pressure.

Valuation caps and discounts determine investor ownership

British Business Bank guidance highlights conversion discounts and valuation caps. A discount lets the note holder convert at a lower price than new investors; a cap can give an even lower effective valuation if the next round valuation is high.

Model several outcomes before signing. A generous cap can create far more dilution than founders expect after a successful growth period.

Interest can accrue and convert with principal

CLNs can charge interest, often at a lower cash rate than high-risk ordinary debt because the investor expects equity conversion. The agreement determines whether interest is paid in cash, accrued or converts into shares.

Accrued interest increases the amount converting. A £500,000 note plus two years of accrued interest can create materially more shares than the founder's original headline calculation.

The company needs a plan if no qualifying round occurs

British Business Bank warns that a CLN can become repayable if the trigger event does not happen by maturity. That can be dangerous for a startup that expected conversion and has not reserved cash for repayment.

Model maturity as a real debt date. Do not assume investors will automatically extend or convert on friendly terms if the business underperforms.

Track the note in both debt and cap-table planning

Finance should record the cash receipt and note liability according to the accounting treatment, while the board maintains a fully diluted cap table showing potential conversion.

Future investors will diligence the note terms. Keep executed documents, interest schedule, conversion model and any amendments together so the next round can calculate ownership accurately.

Worked example: a startup issues a £500,000 CLN with a 20 percent discount and £5 million valuation cap. The next round values the company at £8 million. The cap can give the note investor a conversion price based on £5 million rather than the higher round valuation, creating more shares than founders might expect from the simple 20 percent discount alone. Model both mechanisms before signing.

Future investors will ask whether conversion happens before or after their new money, how accrued interest converts, and whether the note has a most-favoured-nation or seniority clause. Those details can affect the economics of the next round. Keep a fully diluted cap table updated from the day the note is issued rather than waiting until conversion.

If the company raises several CLNs at different caps or discounts, maintain a separate schedule for each instrument. Combining them into one generic convertible balance can make the eventual share calculation error-prone and can create disputes with investors.

Clarify ranking against existing debt. A CLN can be unsecured and subordinated, but the documents can also give investors protections that matter in an insolvency or sale. Future bank lenders will want to know where the note sits in the capital structure and whether consent is needed for new security.

At each funding round, update the conversion model using the actual round terms before directors approve new shares. Small changes to pre-money valuation, option pool or round size can materially alter the number of shares issued to note holders. The conversion should be independently checked, not copied from the original fundraising spreadsheet.

After conversion, close the note liability and retain the historic interest calculation. Auditors and future investors may need to understand why the number of shares issued exceeds the original cash amount divided by the new round share price.

Check whether the note includes automatic conversion on an exit before the next funding round. An acquisition can trigger repayment, conversion or a premium depending on the document, and those outcomes change how sale proceeds are divided. Founders should understand the exit waterfall before accepting a buyer offer.

Do not treat the maturity date as a distant legal detail. Add it to the same financing calendar as bank maturities and option expiries. Investors are much easier to negotiate with months before maturity than days before a large repayment becomes due.