When a business is seeking to raise finance it can either do so using debt or equity. There is however a hybrid alternative type of debt referred to as convertible loan notes or convertible promissory notes. With convertible debt the lender has the option to convert the loan into equity at a later date when a trigger event (such as a venture capital seed round) occurs.
The convertible loan notes are in effect interest bearing loans which, instead of being repaid with interest in cash, are repaid by the issue of equity to the lender.
Whilst it is possible to have a convertible loan to a single lender, due to the amounts involved, it is more usual to issue convertible loan notes to multiple lenders referred to as noteholders.
Convertible Debt Startup Financing
Convertible loan notes are often used by debt financing startup businesses as they avoid the need to establish a valuation for the business until a later date. The relatively simple structure of convertible debt for startups makes the process faster and therefore cheaper than raising equity finance.
Key Convertible Loan Notes Features
Convertible loan notes differ depending on the circumstances of the fund raising, however there are key features and terms common to all convertible loan notes.
- Trigger event: The note is converted into equity when a trigger event takes place. The trigger event might be a seed round of equity financing, a takeover, or the maturity date of the loan note.
- Maturity date: The maturity date is the expiry date for the loan notes, and in the absence of any other trigger event is the date when the note is due to be repaid to the note holder together with any accrued interest.
- Interest rate: This is the rate at which interest will accrue on the loan. Depending on the loan agreement the interest might be either simple or compound interest.
- Cap: The cap sets the maximum valuation at which the loan note can be converted. It is designed to protect the noteholder in the event that the valuation of the business grows.
- Discount: The discount is given on the valuation to compensate the noteholders for funding the business at an early stage.
Convertible Loan Notes Example
Consider a business which currently has 500,000 shares issued to the founders and is seeking to secure additional investment of 1,000,000 based on a pre-money valuation of 3,000,000.
The business also has convertible loan notes issued 2 years ago on the following terms.
- Trigger event: Investment greater than or equal to 1,000,000
- Interest rate: Simple interest accrued at 4% a year.
- Cap: 2,000,000
- Discount: 20%
Convertible Loan Notes Balance
The convertible loan notes will have accrued interest over the year since it was issued. Assuming simple interest (as opposed to compound interest), the balance on the loan notes is calculated as follows:
Interest = Principal x Rate x Term Interest = 100,000 x 4% x 2 Interest = 8,000 Loan balance = Principal + Interest Loan balance = 100,000 + 8,000 = 108,000
Conversion Value of the Loan Notes
The conversion value of the loan notes depends on the discount (20%) and the cap value (the maximum valuation (2,000,000) allowed under the convertible loan notes agreement).
The amount converted to shares will be the higher of the conversion value calculated using the discount percentage, and the value calculated using the cap.
Conversion Value Using the Discount Percentage
The discount percentage is used to calculate a conversion value as follows:
Conversion value = Loan note balance / ( 1 - Discount %) Conversion value = 108,000 / ( 1 - 20%) Conversion value = 135,000
Conversion Value Using the Cap
The valuation cap is used to calculate a conversion value as follows:
Conversion value = Loan note balance x Pre-money Valuation / Cap Conversion value = 108,000 x 3,000,000 / 2,000,000 Conversion value = 162,000
The discount percentage produces a loan note conversion value of 135,000 compared to the value using the cap valuation of 162,000. Since the noteholder is entitle to the highest conversion value the amount of 162,000 is used.
The percentage shareholdings post investment are calculated based on the value attributable to the shareholder relative to the post-money valuation. In this example the post money valuation is given as follows:
Post-money valuation = Pre-money valuation + Investment Post-money valuation = 3,000,000 + 1,000,000 = 4,000,000
% Shareholding = Investment / Post-money valuation % Shareholding = 1,000,000 / 4,000,000 = 25%
% Shareholding = Conversion value / Post-money valuation % Shareholding = 162,000 / 4,000,000 = 4.05%
The founders are diluted by the issue of the new shares to the investor and the noteholder and their percentage falls from its original 100% as follows:
% Shareholding = Founder value / Post-money valuation % Shareholding = (Pre-money valuation - Loan note value) / Post money valuation % Shareholding = (3,000,000 - 162,000) / 4,000,000 % Shareholding = 2,838,000 / 4,000,000 % Shareholding = 70.95%
Number of New Shares to be Issued
New shares need to be issued to the investor and the noteholder which will have the effect of diluting the founders.
In this example, there are currently 500,000 shares in issue held by the founders which, as the calculation above shows, must represent 70.95% of the post-money shareholdings. The total number of shares required is therefore calculated as follows:
Total shares = Founder shares / Founder % Total shares = 500,000 / 70.95% Total shares = 704,722
The total number of shares needed is 704,722, and therefore the new shares to be issued is 704,722- 500,000 = 204,722. The investor will receive 704,722 x 25% = 176,180 shares, and the noteholder will receive 704,722 x 4.05% = 28,541 shares
The share price for the investor and the noteholder can be calculate by dividing the amount paid for the shares by the number of shares as follows:
Share price = Amount paid / Number of shares Investor share price = 1,000,000 / 176,180 = 5.676 Noteholder share price = 108,000 / 28,541 = 3.784 Effective cap discount = (5.676 - 3.784) / 5.676 = 33.33%
As a result of the cap value (2,000,000) being used on the convertible loan notes the effective discount given to the noteholder is 33.33%.
The post-money changes are summarized in the following table.
The calculations performed above are examples only to demonstrate the process behind the conversion of loan notes. They are based on the assumption that the percentage the investor is purchasing is fixed (in this case 25%). Other methods are available and care needs to be taken in real life situations that the calculations are performed in accordance with whatever agreements, including any convertible loan agreement, are in place. Always consult a professional advisor.