Convertible Loan Notes: a compromise between cash now and equity later

Picture this: You receive a loan to help fund your growing business. Instead of regular repayments, you provide two options to the lender. They can either (i) receive the principal and interest after an agreed period e.g. four years; or (ii) if they see potential in your budding business, instead of repayment, they can convert their loan into shares. Conversion usually occurs automatically if the company receives a material investment e.g. venture capital.

This "either-or" arrangement is essentially a convertible loan note. It's a loan that can either be paid back in cash or converted into ownership in the company.

7 reasons why this might be a preferred approach for an early-stage company:

1. Deferred Valuation: For early-stage companies, determining a company's valuation can be challenging or impossible. Convertible loan notes defer agreement on a valuation until a later funding round, at which point the company might have a clearer, more established value.

2. Convenience: It provides quick cash, which is often crucial for growing businesses. Without the need to immediately establish company valuation, the negotiation process with investors can be quicker and less complex.

3. Fewer Legal Formalities: Compared to traditional equity rounds, convertible loan notes often involve fewer legal hurdles (depending on the investor), making them a cost-effective and quicker method of raising capital.

4. Attracting Investors: Investors can somewhat de-risk their investment. It’s a win-win: they either get their money back with interest or a stake in a potentially successful business.

5. Less Dilution Upfront: Business owners can retain more of their ownership in the early stages of their company, allowing them to maintain control and only dilute ownership if and when the convertible loan note converts.

6. Reduced Cash Burn: Unlike traditional loans that require regular repayments, convertible loan notes either delay repayment or obviate the need altogether if converted into shares.

7. Bridge Financing: Companies regularly use convertible loan notes to raise money between equity rounds, or to fund an unforeseen opportunity or expense.

TL;DR: A convertible loan note is a short-term debt instrument that can either be repaid or convert into equity in the future, allowing the startup to raise funds from investors without immediately determining a fixed valuation.