What is a convertible loan note and how does it work for a startup?

Full answer

A convertible loan note is a hybrid funding instrument widely used in early-stage UK startups. Legally it begins as a loan: the investor lends money, and the note sets a term, an interest rate, and a maturity date. But the intention is rarely repayment in cash. Instead, on a defined trigger - usually the company's next priced equity round - the loan plus any rolled-up interest converts into shares. The appeal is speed and deferral. Negotiating a company valuation is slow and contentious for a young business with little trading history. A CLN sidesteps this by letting the investor put money in now and fixing the valuation later, when the priced round provides a market reference. To reward the investor for early risk, the note typically includes a discount (for example converting at 20% below the new round's price) and often a valuation cap (a maximum valuation at which their money converts, protecting them if the company's value jumps). Worked illustration of the mechanism: an investor lends GBP 100,000 with a 20% discount. If the next round prices shares at GBP 1.00, the investor's note converts at GBP 0.80, giving them 125,000 shares instead of 100,000 - more equity for the same money, reflecting their earlier risk. Interest, if it accrues, usually rolls into the conversion rather than being paid in cash. Who it affects: founders raising a bridge or seed round, and angel or seed investors. A key UK consideration is tax relief - SEIS and EIS relief generally require shares to be issued, so a plain convertible loan note often does not qualify at the point of lending, which can deter UK angels. For this reason an Advance Subscription Agreement (ASA), which is treated as an equity advance rather than a loan, is frequently preferred where EIS/SEIS relief matters. Because terms (discount, cap, interest, triggers) are bespoke and tax treatment is fact-specific, take qualified legal and tax advice before issuing or signing a CLN.