Last month, Seedrs, one of the main crowdfunding platforms in the UK, started to offer the opportunity to invest in convertible loan notes in addition to traditional equity and debt. Here at TLT, our team has also worked on an increasing number of convertible loan note financings, both company-side and for the investors, demonstrating increasing take-up of this type of instrument.
A convertible loan note (or "convertible") is essentially a loan made by an investor to a company, which bears interest and is repayable at a point in time in the future like any other loan, but which has the right to convert that debt into shares in the company upon the occurrence of a future event. This event is typically an equity fundraising, where the holder of the convertible has the right to convert his debt at a discount to the share price of the funding round, or an exit.
Convertibles are much more common in the US, although they have not been widely taken up in the UK as they do not, at present, enable the investor to benefit from Seed Enterprise Investment Scheme relief or Enterprise Investment Scheme relief, both of which are highly valuable to business angels. However, it was announced in the 2014 Budget that this was going to be reviewed, so there is some expectation this will change for 2015 tax year.
Convertibles are used, in our experience, in a bridging finance capacity – where the company needs to raise money quickly, usually as working capital for growth, in anticipation of an equity round closing in the near future (eg within 3 – 6 months). The documentation is straightforward and can be agreed quickly, with the key commercial term being the discount rate to the next round. From the investor's perspective, this needs to be sufficient to compensate them for the risk they are taking with their capital, and the fact they will not (at present) get the benefit of SEIS or EIS relief. There is no hard and fast rule on this, but we typically see discounts of around 20% being agreed where all parties have some comfort that the future round will be completed in the next few months.
Investors subscribing for convertibles should also be aware that it is unlikely they will get the benefit of any warranties about the company they are investing in, or have some of the controls over the company that they might expect as a shareholder (hence the documentation being more straightforward). We have therefore seen them used more often by existing investors supporting a portfolio company, rather than investors coming in for the first time, so it will be interesting to see the traction that Seedrs get with their new offering.
In the US, YCombinator have developed an instrument called a "SAFE" – a Simple Agreement for Future Equity, which is designed to work like a convertible but without the downsides of debt from the perspective of a start-up. Under a SAFE, the investor pays a sum to the company in return for an option to acquire shares at a discount in a future investment round. However, the capital invested does not bear interest or have a fixed repayment date, with the investor only having the ability to get his capital back on a future sale, listing or winding-up. This is clearly a beneficial arrangement for the start-up, but the investor does take the risk that none of the trigger events (a sale, listing or future equity round) ever takes place. As a result, we do not expect to see "SAFEs" being taken up by the UK investment community, at least until SEIS and EIS relief is available for this type of instrument.
So, the message is very much one of watch this space – if EIS and SEIS become available for convertibles, we should expect them to become a more mainstream instrument for business angels in the future.
This publication is intended for general guidance and represents our understanding of the relevant law and practice as at August 2014. Specific advice should be sought for specific cases; we cannot be held responsible for any action (or decision not to take action) made in reliance upon the content of this publication.
TLT LLP is a limited liability partnership registered in England & Wales number OC 308658 whose registered office is at One Redcliff Street, Bristol BS1 6TP England. A list of members (all of whom are solicitors or lawyers) can be inspected by visiting the People section of this website. TLT LLP is authorised and regulated by the Solicitors Regulation Authority under number 406297.