Convertible Loan Notes for Startups

A convertible loan note (CLN) is a short-term loan that converts into equity shares at a later date, typically when the company raises its next round of funding. Convertible loan notes are one of the most common instruments used to fund early-stage UK startups, particularly in the gap between incorporation and a priced equity round.

For founders, CLNs provide funding without the need to agree a company valuation at a stage when valuation is difficult or contentious. For investors, they offer the protection of a debt instrument with the upside potential of equity.

How convertible loan notes work

The investor lends money to the company under a loan agreement. Instead of being repaid in cash, the loan converts into shares when a specified trigger event occurs – most commonly a qualifying equity funding round.

Typical lifecycle

1. Investor advances funds to the company under a CLN agreement
2. The company uses the funds for working capital, product development, hiring or other operational needs
3. A trigger event occurs – usually a qualifying funding round above a minimum size
4. The loan converts into shares at a price determined by the CLN terms (typically at a discount to the price paid by new investors in the funding round)
5. The investor becomes a shareholder and the loan is extinguished

If no trigger event occurs before the maturity date (often 12-24 months), the CLN terms specify what happens. Options include repayment in cash, conversion at a pre-agreed valuation or an extension of the loan.

Key terms

Discount vs valuation cap

Most CLNs include either a discount rate or a valuation cap, and some include both (in which case the investor gets whichever produces more shares):

Why startups use CLNs

Advantages for founders

• Speed – CLN documentation is simpler and cheaper than a full equity round. A CLN can be completed in days rather than weeks
• Defer valuation – no need to negotiate a company valuation at a stage when there is little data to support one
• Lower legal costs – typically £2,000-£5,000 compared to £10,000-£30,000+ for a priced equity round
• Flexibility – terms can be tailored to the situation

Advantages for investors

• Downside protection – as a creditor, the investor ranks ahead of shareholders if the company fails
• Discount or cap – the conversion terms compensate the investor for the early risk
• SEIS/EIS eligibility – if structured correctly, CLN investments can qualify for Seed Enterprise Investment Scheme (SEIS) or Enterprise Investment Scheme (EIS) tax relief on conversion (though advance assurance from HMRC is recommended)
• Simplicity – less negotiation and documentation than a full equity round

Accounting treatment

At issue

When the company receives the CLN proceeds, the entry is:

The CLN is recorded as a financial liability on the balance sheet.

Interest accrual

If the CLN carries interest, accrue it periodically:

The accrued interest increases the liability because it will convert into shares alongside the principal.

On conversion

When the CLN converts into equity:

The liability is extinguished and replaced by equity. No cash changes hands.

Under FRS 102

For companies reporting under FRS 102 (the standard for most UK SMEs), the CLN may need to be split into a debt component and an equity component if the conversion feature is at the holder’s option. In practice, most startup CLNs convert automatically on a trigger event, which simplifies the accounting.

If the CLN is a basic financial instrument under FRS 102 Section 11, it is measured at amortised cost. If it has complex features (e.g. investor option to convert at any time, variable conversion ratios), it may fall under Section 12 and require fair value measurement.

Take professional advice on the classification if your CLN has non-standard features.

Tax implications

Corporation Tax

• Interest accrued on the CLN is generally deductible for Corporation Tax purposes as a finance cost, provided it is at a commercial rate
• On conversion, the interest deduction may be challenged by HMRC if the interest was never actually paid in cash. Seek advice on the specific terms

Stamp duty

• No stamp duty is payable on the issue of a CLN
• On conversion, shares are issued rather than transferred, so no stamp duty applies (stamp duty applies to share transfers, not new issues)

SEIS and EIS

CLN investors can potentially claim SEIS (50% income tax relief) or EIS (30% income tax relief) when the loan converts into qualifying shares. The relief applies at the point of conversion, not at the point of lending. The company should obtain advance assurance from HMRC before the investment to confirm eligibility.

Key conditions include:

• The shares issued on conversion must be ordinary shares with no preferential rights to dividends or assets
• The company must meet the qualifying criteria (trading company, not in excluded sector, under the gross assets and employee limits)
• The CLN must convert within a reasonable timeframe

CLNs vs equity rounds

CLNs vs equity financing – when to use which

Use a CLN when:

• You need to raise a small amount quickly (typically under £500,000)
• You cannot yet justify or agree a valuation
• You want to keep legal costs low
• The funding is a bridge to a larger round

Use a priced equity round when:

• You are raising a substantial amount (£500,000+)
• You have enough traction to support a credible valuation
• Investors want immediate shareholder rights (board seat, information rights, anti-dilution)
• Multiple investors are participating and need aligned terms

Practical considerations

• Keep the terms simple – complex CLNs with multiple conversion mechanisms create accounting headaches and future negotiation problems
• Set a realistic maturity date – if the trigger round does not happen in time, you need a workable fallback
• Cap the total CLN issuance – too many CLNs outstanding dilute the founders significantly on conversion
• Get advance assurance for SEIS/EIS if your investors want tax relief
• Use a standard template – the British Private Equity & Venture Capital Association (BVCA) and the Seed Enterprise Investment Scheme Association publish standard CLN templates
• Inform existing shareholders – issuing CLNs may require board or shareholder approval depending on your articles of association