Alex is Sprintlaw’s co-founder and principal lawyer. Alex previously worked at a top-tier firm as a lawyer specialising in technology and media contracts, and founded a digital agency which he sold in 2015.
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Raising money without locking in a valuation can be a smart move for an early-stage business. That’s exactly where convertible loan notes can help.
If you’ve been told to “just do a convertible” but aren’t sure what that actually means in the UK, don’t stress - below we break down what convertible loan notes are, how they work in practice, the main legal and tax traps to avoid, and the documents you’ll need to get it done properly.
Getting your legal foundations right from day one will save you headaches later, especially when your note converts and new shareholders join your cap table.
What Is A Convertible Loan Note?
A convertible loan note (often shortened to “convertible note” or “CLN”) is a loan that can convert into shares in your company in the future, rather than being repaid in cash. Until it converts, it’s treated as debt - usually with interest and a maturity date.
Startups and small businesses like CLNs because they allow you to raise capital quickly without agreeing a full company valuation right now. Instead, you and your investor agree the conversion mechanics (for example, a discount or valuation cap) and the note will convert when a trigger event happens, like your next equity round.
In short: a CLN gives you cash today, defers valuation negotiations, and (if all goes well) turns that debt into equity later.
How Do Convertible Loans Work In Practice?
While every deal is different, most UK convertible loan notes share a handful of familiar terms. Here’s the plain-English version of what you’ll likely see and what it means for your business.
Common Features And Terms
- Principal: The amount the investor is lending your company.
- Interest: Often simple interest (e.g. 6–10% p.a.), sometimes accruing and capitalised on conversion.
- Discount: A percentage reduction applied to the price per share in the next qualified funding round (e.g. 15–25% discount).
- Valuation Cap: A maximum valuation used to calculate the conversion price, protecting the investor if your next round is at a very high valuation.
- Maturity Date: The date on which the loan either converts (at a pre-agreed formula) or becomes repayable if no trigger event has occurred.
- Qualified Financing: A defined equity raise that meets certain criteria (e.g. a minimum aggregate raise) and triggers conversion.
- Conversion Mechanics: How many shares are issued, what class they are (often the next round preference shares), and how price is calculated if there’s no qualified round by maturity.
- Most Favoured Nation (MFN): If you issue later notes on better terms, earlier noteholders can elect to adopt those better terms.
- Security And Ranking: Most early-stage CLNs are unsecured and rank alongside other unsecured creditors, but some investors ask for security.
Triggers For Conversion Or Repayment
- Next Funding Round: The most common trigger; the note converts at a discount and/or subject to a valuation cap.
- Maturity: If no qualified round happens by the maturity date, the note may convert at a pre-agreed valuation or become repayable (sometimes with a premium).
- Sale Or IPO: On an exit event, the note may convert immediately or repay with a multiple; this is a negotiation point.
- Default: Certain “events of default” (e.g. insolvency or covenant breaches) can give investors enforcement rights or early conversion options.
It’s worth aligning these concepts up front in a short, non-binding Term Sheet. A term sheet helps avoid misunderstandings before you move to long-form documents.
What Happens On Conversion?
When a trigger occurs, you calculate the conversion price using the agreed formula. The loan principal (and any accrued interest that converts) is divided by that price to determine the number of shares issued to the investor. You’ll pass board and (if required) shareholder resolutions to approve the allotment, file your SH01 at Companies House within 30 days, update your statutory registers and cap table, and get the investor to sign a deed of adherence to your Shareholders Agreement.
Benefits And Risks For UK Small Businesses
Convertible loans can be fast and flexible - but they’re not a perfect fit for every business. Here’s the balanced view.
Benefits
- Speed To Close: CLNs are typically quicker and cheaper to document than a full equity round.
- Defer Valuation: Useful if your business is too early to price confidently.
- Alignment: Investors share in upside on conversion rather than demanding early repayment.
- Bridge Financing: Helpful to “bridge” to your next institutional round.
Risks And Trade-Offs
- Debt Until It Isn’t: It’s still a loan. If you reach maturity without a conversion trigger, you may face a repayment obligation.
- Dilution Unknowns: Discounts and caps can cause more dilution than expected; model multiple scenarios before signing.
- Interest And Withholding: Interest adds to the conversion amount (or cash cost) and may have UK withholding implications.
- SEIS/EIS Eligibility: Traditional CLNs often don’t qualify for SEIS/EIS tax relief, which can put off some angel investors.
- Investor Protections: MFN and restrictive covenants can limit future flexibility if not carefully drafted.
Alternatives To CLNs
- Advanced Subscription Agreement (ASA): An equity instrument that takes money now for shares issued later, typically without interest or repayment rights. Many angels prefer an Advanced Subscription Agreement, and HMRC guidance has historically treated ASAs more favourably than loans for SEIS/EIS eligibility when properly structured.
- SAFE: A US-style agreement. In the UK, a SAFE vs ASA comparison is common - most UK deals lean toward ASAs to align with local tax and company law norms.
- Equity Round: Price the round today using a Share Subscription Agreement if you and your investors can agree valuation and terms now.
Legal And Compliance Checklist (UK)
Convertible notes are simpler than a full equity round, but you still need to tick key UK legal boxes. Here’s a practical checklist.
1) Companies Act 2006 Authority And Pre-Emption
- Authority To Allot: Ensure directors have authority under section 551 to allot the shares that will be issued on conversion. This is usually granted by ordinary resolution.
- Pre-Emption Rights: Under sections 561–576, existing shareholders may have rights of first refusal on new shares. Disapply these rights (by special resolution) for the shares to be issued on conversion, or plan for a pre-emption process.
- Articles Of Association: Check your articles for any bespoke consent thresholds or class rights that could affect conversion. Update if needed before you sign the note.
2) Financial Promotion (FSMA 2000)
Inviting or inducing someone to invest is regulated under the Financial Services and Markets Act 2000 (FSMA). Unless an exemption applies (e.g. high net worth or self-certified sophisticated investors, or communications made via an FCA-authorised firm), financial promotions can be unlawful. Make sure your fundraising materials are targeted appropriately and include the right investor certifications.
3) Security And Registration Of Charges
Most early-stage CLNs are unsecured. If an investor does take security, you’ll need to register the charge at Companies House within 21 days (using an MR01) to ensure it’s enforceable against third parties.
4) Events Of Default And Covenants
Be realistic about the promises you’re making while the note is outstanding. Overly tight covenants can trip “events of default” and force early repayment or enforcement. If you’re unsure which events are market standard or how they operate, have a read on events of default and get them tailored to your risk profile.
5) Share Issuance Mechanics And Filings
- Board And Shareholder Resolutions: Approve the note now; approve the share allotment on conversion.
- Companies House: File SH01 within 30 days of allotment; update your registers and PSC details if applicable.
- Shareholders Agreement: Ensure the new holder signs a deed of adherence to your Shareholders Agreement at conversion.
6) Insolvency And Director Duties
If cash gets tight, remember your duties under the Insolvency Act 1986 - avoid wrongful trading and consider creditor interests. A CLN is debt until conversion, so lenders are creditors before they become shareholders.
Tax, SEIS/EIS And Valuation Considerations
Tax is a major reason many UK founders and angels consider ASAs rather than loan notes. Here are the practical points to discuss with your advisers.
SEIS/EIS Treatment
- CLNs: Traditional CLNs (with interest and a real possibility of repayment) generally do not qualify for SEIS/EIS relief. That can deter investors who rely on these schemes.
- ASAs: Properly structured ASAs are more likely to qualify because they are equity-like and do not carry repayment rights - another reason many UK deals favour an Advanced Subscription Agreement over a loan.
Interest And Withholding Tax
UK withholding tax can apply to yearly interest at the basic 20% rate unless an exemption or treaty relief applies. Many early-stage CLNs therefore use non-compounding simple interest that converts to equity, or they opt for equity-like instruments with no interest. Get tax advice early so you’re not caught out.
Valuation: Caps, Discounts And Dilution
Discounts and valuation caps are the levers that determine how many shares are issued on conversion. Model different scenarios so you and your investor are aligned on likely dilution. If you expect to set up an option scheme after conversion, keep an eye on how the post-money option pool and any UMV valuation might be affected.
Debt-For-Equity Mechanics
On maturity (or in tricky situations), you might negotiate a debt-for-equity swap. This allows the outstanding loan (plus accrued interest) to be capitalised into shares at an agreed price, avoiding immediate cash repayment. It’s essential to document the swap carefully and complete the company law steps for allotment.
Documents You’ll Need And A Simple Step-By-Step Plan
Here’s a practical roadmap you can follow, plus the core documents that make a CLN work smoothly in the UK.
Core Documents
- Term Sheet: A short document that records headline terms (discount, cap, interest, maturity, triggers). Using a clear Term Sheet saves time and sets the tone for drafting.
- Convertible Loan Note Agreement: The full legal document covering payment mechanics, conversion, events of default, covenants, and representations. Work with a lawyer who drafts these frequently - off-the-shelf forms tend to miss key UK-specific points. If you want fixed-fee support, our Convertible Note package covers drafting and guidance.
- Board And Shareholder Resolutions: Authority to enter the note now and to allot shares on conversion (including disapplication of pre-emption rights where needed).
- Articles Review/Amendment: Make sure your Articles allow for the class of shares to be issued on conversion and any required investor rights.
- Shareholders Agreement (and Deed Of Adherence): Get your investor to adhere to your Shareholders Agreement on conversion so everyone is bound by the same rules.
- Share Subscription Agreement: If you end up pricing a round instead, you’ll use a Share Subscription Agreement and convert the note into that round’s share class using the agreed formula.
Step-By-Step Plan
- Align Internally: Decide whether a CLN is right for your goals (speed vs. SEIS/EIS, interest, repayment risk). Consider if an ASA is more suitable for angel demand.
- Set The Headline Terms: Prepare and negotiate a concise Term Sheet covering discount, cap, maturity, interest, triggers and any MFN or covenants.
- Get Authority And Consents: Check Articles, obtain s551 allotment authority and disapply pre-emption rights for conversion shares. Ensure any investor consent thresholds in your existing documents are met.
- Draft The Convertible Note: Use a UK-appropriate template tailored to your deal. Avoid copy-pasting from US forms - UK company law and tax are different.
- Complete And Fund: Sign the note, pass board resolutions, receive funds, and set up a simple tracker for principal and interest.
- Monitor Covenants And Dates: Diary the maturity date, interest accruals and any information undertakings. Stay ahead of timelines to avoid inadvertent defaults.
- Convert Or Repay: On a qualified financing, run the conversion mechanics, allot the shares, file SH01, update registers, and have the investor sign a deed of adherence to your Shareholders Agreement. If no trigger occurs by maturity, negotiate extensions, conversion at a fixed price, or repayment. When things get complex, consider a structured debt-for-equity swap.
If you’re weighing up instruments, it can also help to compare a UK-style ASA with a SAFE using this SAFE vs ASA overview and speak to your investors about what they prefer.
Key Takeaways
- Convertible loan notes let you raise now and defer valuation - the loan typically converts into shares in your next round at an agreed discount and/or cap.
- They’re faster than an equity round but still debt until conversion, so plan for maturity, interest, and the possibility of repayment if no trigger event occurs.
- Get the UK legal basics right: s551 allotment authority, pre-emption disapplication, Articles checks, Companies House filings, and compliant financial promotions under FSMA.
- Model dilution carefully. Discounts and valuation caps can be powerful - run scenarios so your team understands the likely outcomes at conversion.
- Tax matters. Traditional CLNs generally do not qualify for SEIS/EIS; many UK angel deals use an Advanced Subscription Agreement to align with investor expectations.
- Use the right documents and process: a clear Term Sheet, a tailored Convertible Note, board/shareholder approvals, and on conversion make sure the new investor signs your Shareholders Agreement.
- If covenants and defaults feel daunting, read up on events of default and get tailored drafting - it’s worth avoiding accidental breaches.
If you’d like help structuring a Convertible Note, switching to an ASA, or preparing the fundraising legals so you’re protected from day one, you can reach us at 08081347754 or team@sprintlaw.co.uk for a free, no-obligations chat.
