Convertible loan notes (CLNs) are a popular way for startups to raise funding from investors, especially those without proven revenue streams. Generally, they are a form of loan that can be converted into shares at a later time at the Company's discretion – at specific rates or in response to certain events.
They will generally be both redeemable and convertible. They can be secured, although often they are not. If they do not have security, they will find themselves next to all unsecured creditors in the event of a liquidation.
The coupon (interest rate) normally paid under CLNs will be higher than an investor could expect if they were to put their money in a savings account.
The interest under CLNs will usually be payable periodically, but it is possible, for example, to agree that the interest will be added and paid when the loan itself is converted or repaid. If the CLNs are converted, interest can also be capitalized.
Whether or not an investor chooses to repay his or her convertible loan at the relevant time will depend on several factors, but mainly on the conversion price.
This is generally set at the notional market value at the time the CLNs are created, or at the actual value if the issuer's shares are publicly traded.
If this market value has increased over time, an investor will typically want to convert their loan into shares. If this market value has fallen, chances are he wants to pay off their loan for cash. Any outstanding interest is treated in the same way as the principal amount.
It goes without saying, but in the event that CLNs are converted, existing shareholders will (all other things being equal) suffer dilution, and in the event that CLNs are redeemed, the issuer will have to find the money to sell them to be repaid.
In summary, convertible loan bonds are a good way for issuers to raise money because they are attractive to potential investors, allowing them to earn healthy returns and gain the benefits of a call option over shares in the issuer at a fixed price.
Issuers generally do not need to secure their assets against the CLNs in order to defer interest and principal payments under the CLNs until maturity, which offers cash flow advantages over traditional borrowing.
Jos Alcraft is a director at law firm Matthew Arnold & Baldwin.
This article was originally published on July 15, 2009 by Hunter Ruthven.
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