What Is A Convertible Loan Note? Key Terms For UK Startups

If you’re raising money for a UK startup, you’ll quickly run into a familiar funding question: what is a convertible loan, and is it the right way to bring in investment without having to agree a valuation straight away?

Convertible loans (often called “convertible loan notes”) are popular with early-stage businesses because they can be faster and simpler than a full priced equity round. But they’re still legal documents with real financial and risk implications - for you, your company, and the investor.

In this guide, we’ll break down what a convertible loan is, how it works in practice, and the key terms you’ll want to understand before you sign anything.

What Is A Convertible Loan?

So, what is a convertible loan in plain English?

A convertible loan is a loan made to your company that can later convert into shares instead of being repaid in cash (or as well as being repaid in cash, depending on how it’s drafted).

In other words, it starts life as debt, but it’s designed to become equity at a later point - usually when you raise your next funding round.

Why Startups Use Convertible Loans

Convertible loans are typically used when:

• You need to raise money quickly (and don’t want the time and cost of a priced equity round).
• Valuation is hard to agree at an early stage (pre-revenue, MVP stage, or when there’s limited market traction).
• You expect a proper funding round soon, and you want the valuation set then.
• You want a bridge between now and your next milestone (product launch, first enterprise contract, regulatory approval, etc.).

Convertible Loan Vs Equity Investment

With a normal equity raise, the investor buys shares now - which means you negotiate valuation now.

With a convertible loan, the investor lends money now and typically becomes a shareholder later, often with a benefit for taking “early risk” (like a discount or valuation cap).

That can feel founder-friendly, but remember: until it converts, it’s still debt sitting on the company’s balance sheet, and it can create pressure if the company doesn’t raise again before the loan matures.

How Do Convertible Loan Notes Work In UK Startup Fundraising?

Convertible loans are usually documented as convertible loan notes (a formal agreement setting out the debt terms and the conversion mechanism). You’ll also hear people refer to a Convertible Note as shorthand for the same concept.

While each deal is different, the typical lifecycle looks like this:

1) The Investor Advances Funds

The investor pays money to your company, and your company agrees it is a loan on agreed terms (principal, interest, maturity date, etc.).

2) A “Conversion Event” Happens

Most convertible loans are structured so that if you later raise a qualifying equity round (often called a “Qualified Financing”), the loan converts into shares if and when the note’s drafted conversion mechanics are triggered. In many cases this is set up as “automatic” conversion, but it’s only automatic if the documents clearly say so.

The conversion price is usually calculated by reference to the new round’s share price, then adjusted using:

• a discount (eg 10–25% cheaper than new investors pay), and/or
• a valuation cap (a maximum valuation used for the conversion calculation).

3) Shares Are Issued

On conversion, the company issues shares to the investor. This normally needs board approval and proper corporate paperwork. In the UK, you’ll also need to ensure the directors have the right Companies Act 2006 authority to allot shares (and, where relevant, to disapply statutory pre-emption rights) and that your articles and any shareholders’ agreement align with what you’re issuing.

It’s also important to sanity-check that the conversion mechanics won’t result in shares being issued at an unlawful discount (for example, where shares aren’t fully paid). And once shares are issued, you’ll want the company’s shareholder arrangements to be up to date - for example, a Shareholders Agreement that sets out key rules around decision-making, exits, and founder protections.

4) If Conversion Doesn’t Happen, The Loan Must Be Dealt With

If the company doesn’t raise another round in time, the maturity date hits - and then what happens depends on the drafting. Options often include:

• repayment of the loan (plus interest),
• conversion at a pre-agreed price, or
• extension of the maturity date (often requiring investor consent).

This is one of the biggest “hidden” risks for founders: if you treat the convertible loan as “basically equity”, but the documents don’t clearly support that, you might end up with a real debt repayment problem later.

Key Convertible Loan Terms You Need To Understand

To properly answer what is a convertible loan (in a way that helps you negotiate one), you need to understand the key commercial and legal terms that drive how much equity you’ll give away - and what pressure points the investor has if things don’t go to plan.

Principal Amount

This is the amount invested (eg £50,000). It’s the starting point for any conversion calculation and usually the amount repayable if the loan doesn’t convert.

Interest

Convertible loans typically accrue interest (eg 4–10% per annum). Interest may:

• be paid in cash (less common in early-stage startups), or
• roll up and convert into shares along with the principal (more common).

If interest is rolling up, it increases the number of shares the investor receives on conversion - which means more dilution for founders.

Maturity Date

The maturity date is when the loan becomes due. If you haven’t raised a qualifying round by then, the investor may have rights to demand repayment or trigger an alternative conversion mechanism.

Founders sometimes focus heavily on discount and cap, but maturity is just as important, because it dictates time pressure.

Discount Rate

A discount gives the convertible lender a better price than later investors.

Example: If the next round price is £1.00/share and the discount is 20%, the conversion price becomes £0.80/share (subject to any cap mechanics).

Valuation Cap

A valuation cap sets a maximum valuation for conversion purposes.

It’s designed to reward early investors if your valuation jumps significantly by the time you raise the next round. From a founder perspective, caps can be fine - but only if they’re realistic and you understand what they do to dilution.

In many deals, the investor gets the better of:

• the discounted price, or
• the price implied by the valuation cap.

Qualified Financing (Conversion Trigger)

This is usually defined as an equity fundraising above a certain amount (eg at least £250,000 or £1m). If you raise less than the threshold, the loan may not automatically convert (or it may convert at a different price).

Getting this definition right matters, because you don’t want to accidentally trigger conversion in a small round on terms that don’t make sense - or fail to trigger conversion when you expected it.

Conversion Mechanics (What Shares Do They Get?)

Conversion isn’t just about price. It’s also about what class of shares is issued and what rights attach to those shares.

For example, will the investor receive the same class of shares issued in the new round? Will they receive preference shares with enhanced rights? Will any investor rights apply immediately?

This is where your early-stage handshake deal can quietly turn into long-term governance complexity.

Most Favoured Nation (MFN) Clause

An MFN clause typically says: if the company issues a later convertible instrument on better terms, the earlier investor can “upgrade” to those better terms.

MFNs can be reasonable, but you should understand the knock-on impact: it may restrict your flexibility in future bridge rounds.

Security (Is The Loan Secured Or Unsecured?)

Some convertible loans are unsecured (common for early-stage startups). Others are secured against company assets (less common early, but possible), often via a debenture.

Security can increase investor leverage if the company struggles. If you’re being asked to provide security, it’s worth getting advice early, because this can affect future fundraising and the company’s risk profile.

Events Of Default

Default clauses set out when the investor can take action, such as demanding repayment, charging default interest, or enforcing security.

Typical defaults might include insolvency events, missed payments (if any), or a breach of key obligations.

For founders, default wording is a key area where a “simple” convertible loan can become stressful, so it’s worth checking these clauses carefully.

Common Legal And Commercial Issues Founders Run Into

Convertible loans can be a great tool - but the devil is in the detail. Here are the issues we commonly see UK startups run into when they don’t slow down and sanity-check the terms.

It’s Still Debt (Until It Converts)

A convertible loan is not equity on day one. This matters because:

• the company has a repayment obligation (unless and until it converts),
• directors need to act in the company’s best interests and consider solvency, and
• other lenders/investors may ask about existing debt when you raise later.

Dilution Can Be Bigger Than You Expect

Discounts, caps, rolled-up interest, and multiple convertible notes stacking over time can significantly increase dilution.

A practical tip: before you sign, model at least three scenarios:

• a “low valuation” next round,
• a “high valuation” next round (cap kicks in), and
• no next round before maturity (what happens then?).

Control And Investor Rights Can Sneak In Early

Some convertible loans include “investor-style” controls before conversion (eg consent rights, information rights, vetoes over major decisions).

That can be fine - but it should be deliberate. If you’re giving away control rights early, make sure you understand the operational impact (for example, needing investor consent to issue shares, take on debt, or change your business model).

SEIS/EIS Compatibility (If Relevant)

Some startups and investors ask whether a convertible loan “qualifies” for SEIS/EIS treatment. This area is technical and depends heavily on structure and current HMRC guidance (which can change), so it’s worth getting tailored advice.

Important: Sprintlaw can help with the legal structuring and documentation, but we don’t provide tax advice. If SEIS/EIS is a driver for the investment, you (and the investor) should confirm the tax position with a qualified tax adviser and consider HMRC clearance where appropriate.

Future Fundraising And Cleanup

Convertible loans can make your next round more complex if the paperwork is unclear. A future lead investor will likely want certainty on:

• exact conversion calculations,
• how many shares will be issued on conversion,
• whether any side rights apply, and
• whether any security was granted.

That’s why it’s common to align key commercial points upfront in a term sheet, even if you want to keep the overall raise lean.

How To Document A Convertible Loan Properly (Without Slowing Down The Raise)

Speed is one of the main reasons founders choose convertible loans - but speed doesn’t mean “wing it”. A messy convertible loan document can cause months of friction later (or worse, trigger disputes when the company is under pressure).

Here’s the practical approach we usually recommend.

1) Agree The Commercial Headlines First

Before anyone starts drafting long-form documents, agree the key commercial points in writing, such as:

• amount invested
• interest rate and whether it converts
• maturity date
• discount and/or valuation cap
• what counts as a qualified financing
• whether the loan is secured

This is often done in a short Term Sheet. It keeps everyone aligned and reduces the chance of surprises later.

2) Use A Proper Convertible Loan Note Agreement

Your convertible loan note agreement should clearly cover:

• Repayment vs conversion: when repayment applies, when conversion applies, and whether conversion is automatic or optional.
• Conversion calculations: discount/cap mechanics and worked examples (often helpful).
• Governance and consents: any investor approvals required before conversion, and the corporate authorities the company will need (eg allotment authority and any required disapplication of pre-emption rights).
• Information rights: what financial updates you need to provide (and how often).
• Default and enforcement: what counts as default and what the lender can do.
• Warranties (if any): what the company is promising to the investor.

Even at seed stage, it’s worth making sure the agreement is properly drafted and internally consistent. If a clause is ambiguous, it can create a dispute right when you’re trying to close a future round.

3) Make Sure It’s Executed Correctly

Convertible loan notes are often executed as deeds (or alongside deeds), depending on the structure and enforcement rights. If you’re unsure about signing formal documents, it’s worth understanding how to sign as a deed, because execution mistakes can undermine enforceability.

More broadly, you want confidence the deal is enforceable and clear - the basics of what makes a contract legally binding still matter here.

4) Keep Your Corporate House In Order

Before you take on convertible debt, check:

• your company’s articles allow the share issues you expect to make later
• you have a clear cap table (who owns what today)
• board and shareholder approvals are properly documented
• you have (or will obtain) the necessary Companies Act authorities to allot shares and, if relevant, disapply pre-emption rights for the conversion shares

This is also a good time to consider whether your existing shareholder documentation is “investor-ready”, because once the loan converts you may need tighter governance. That’s where a well-structured Shareholders Agreement can save a lot of headaches.

5) Don’t Forget The Practical Negotiation Points

Here are a few founder-friendly negotiation tips that can make convertible loans more manageable:

• Don’t accept an unrealistically short maturity date if your fundraising timeline is uncertain.
• Be careful with heavy consent/veto rights before conversion (you still need to run the business).
• Avoid unclear conversion drafting - it almost always gets revisited later, and by then you have less leverage.
• Think about follow-on fundraising and whether MFN clauses or security will put off future investors.

If you’re raising from multiple investors, consistency also matters - you don’t want five different documents with five different conversion formulas.

Key Takeaways

• What is a convertible loan? It’s a loan to your company that’s designed to convert into shares later, usually at your next funding round (if the agreed conversion triggers and mechanics are met).
• Convertible loans can help you raise faster and defer valuation, but they are still debt until they convert.
• The key terms that drive outcomes are maturity date, interest, discount, valuation cap, and qualified financing triggers.
• Watch out for issues that can trip you up later, including unexpected dilution, investor control rights, defaults, and security.
• Even if you want a lean raise, it’s smart to document the commercial headlines in a term sheet and use a properly drafted convertible loan note agreement.
• Getting the details right upfront makes your next fundraising round smoother and helps keep your business protected from day one.

If you’d like help putting a convertible loan in place (or sense-checking the terms before you sign), you can reach us at 08081347754 or team@sprintlaw.co.uk for a free, no-obligations chat.