What are Convertible Loan Notes?

The path to securing the necessary capital is fraught with decisions that can significantly impact a company’s future. Among these, the choice between equity and debt financing is critical. Convertible Loan Notes (CLNs) are a strategic financing option for many startups, offering flexibility and a range of advantages that can empower your funding decisions.

However, it’s crucial to understand their mechanics and explore whether the dilutive nature of Convertible Loan Notes are suitable for your business, or whether non-dilutive funding may be better.

Convertible Loan Notes Summarised

Convertible Loan Notes (CLNs) blend debt with potential equity, offering a versatile funding option for startups. These instruments allow for the conversion of a loan into equity under specific conditions, such as during a subsequent funding round. This enables startups to defer their valuation, preventing the immediate dilution of founders’ equity. More importantly, it provides a flexible, investor-friendly funding mechanism during the critical early stages of growth. The inherent flexibility of CLNs reassures startups that they can adapt their funding strategy as their needs evolve, instilling confidence in their financial planning.

Key Advantages of Convertible Loan Notes

• Deferred Valuation: By using CLNs, startups delay setting their company’s value. Early valuation can be difficult and subjective. By waiting, the company can prove its worth and reach key achievements. This could result in a higher value later, reducing how much ownership founders have to give away.
• Flexible Terms: The terms of CLNs have adjustable conditions like discounts when they’re turned into equity and limits on how high the company’s value can be set at that time. These conditions help early investors pay less than those who invest later and keep their investment safe by not letting the company’s value go too high. This makes CLNs very useful for meeting the different needs of startups and their investors.
• Immediate Capital with Future Equity: CLNs provide startups with the essential capital they need to scale operations, improve their products, and expand into new areas without giving away ownership. This immediate capital injection from CLNs fuels your growth plans and instils a sense of security, ensuring you have the financial stability to pursue your ambitions. For investors, this setup means they get a chance to own a part of the company later on, which helps them and the company work together towards long-term success.

The Problem with Dilutive Funding

Convertible Loan Notes (CLNs) are a great way for startups to get the money they need but they are a source of dilutive funding. This means that they lead to a loss of equity for the original owners of the company. When CLNs are turned into shares, it marks a key moment for the founders. They give up some ownership in exchange for the investment that supported their initial growth. This decrease in ownership is a normal part of changing the loan into shares, usually triggered by something like starting a new funding round.

The Effects of Losing Shares from Convertible Loan Notes

Turning convertible loan notes into shares doesn’t just change who owns what percentage of the company; it can also change who gets to make decisions. Depending on how many shares are lost, they might have less say in company choices. How much they’re affected depends on the details in the CLN agreement, like how much of a discount early investors get and if there are any limits on how much the company can be valued during the conversion.

Discounts for Early Investors

These discounts let CLN investors turn their loans into shares at a lower price than what later investors might pay. While this is good for early investors because they get more shares for their money, it also reduces the percentage of the company the existing shareholders own.

Limits on Valuation

These limits stop investors from overpaying by setting a maximum company value for when the loan turns into shares. If the company’s value is above this limit when converting, investors get shares as if the company were worth a lower amount.

Non-Dilutive Funding Options as an Alternative

Given the pitfalls associated with dilutive funding, the appeal of non-dilutive funding becomes increasingly evident. Non-dilutive funding relates to capital investment that does not require equity in return, such as grants or loans. This type of funding allows startups to retain full ownership, control, and preservation of their vision.
Non-dilutive funding offers several advantages. To name a few:

1. Preservation of Equity

One of the most significant benefits of non-dilutive funding is the preservation of equity. Founders do not see their ownership stakes diluted, enabling them to retain more control over the company. This control is crucial for those deeply invested in maintaining their original vision for the business and ensuring they have a significant influence over its strategic decisions. Further to this, by avoiding dilution, the existing shareholders have the opportunity to earn more from dividends (should they have a successful financial year).

2. Autonomy in Decision-Making

The absence of equity exchange in non-dilutive funding allows freedom in steering the company. This enables founders to prioritise decisions that align with their original vision and long-term objectives without catering to the short-term interests or strategies investors prefer. It ensures that the foundational principles and goals the company was built upon remain intact, fostering an environment where innovation and unique strategic moves are encouraged, unhampered by external pressures to conform or deliver immediate returns to shareholders.

3. Financial Health

Successfully utilising non-dilutive funding is a strong indicator of a startup’s financial stability and capability to thrive independently. By generating revenue or winning grants, these startups showcase their ability to sustain operations without diluting equity and prove their market viability and operational efficiency. This demonstration of financial health makes them more appealing to potential investors in future funding rounds. It signals that the startup is a lower-risk investment, as it has already shown it can attract customers, achieve sales, or meet the rigorous criteria for grant awards, all of which contribute to a solid foundation for growth and profitability.

So, Dilutive or Non-Dilutive Funding?

As dilutive funding can significantly alter a startup’s ownership and control dynamics, non-dilutive funding can stand as a great option for growth companies or innovation start-ups. It allows them to grow and scale their operations while preserving their equity, maintaining decision-making autonomy, and demonstrating financial health. These advantages not only help safeguard the founders’ vision but also position the startup more favourably for future growth and investment opportunities.

A Non-Dilutive Funding Option for Innovative SMEs

If you are an innovative SME and have acquired R&D tax credits, at SPRK Capital we can offer you with access to capital over 36 months based on this R&D tax credit. Our Innovation Term Loan is a great way to advance your R&D claim by up to 150%. It’s a non-dilutive source of funding, and so you won’t lose equity.

If you’re looking for funding solutions, just get in touch with our team of experts and we can advise you on where to go next.