When investors think of backing early-stage companies, the first thing that comes to mind is traditional equity financing.
However, as investors battle the economic uncertainty of current times, convertible loan notes (or CLNs) could be the best compromise.
A hybrid between debt and equity, they offer investors the protection that an equity holder would have if the company dissolves, with the added security and income of debt.
How CLNs work
CLNs are short-term debt instruments through which loans are converted into equity shares at a later date.
They present an opportunity for investors looking for added protections during a crisis-riddled economy. While CLNs are not S/EIS eligible, they offer different rewards for those willing to take an early risk.
CLNs start out as debt and get converted into equity during the next qualifying funding round or agreed upon date. Instead of paying back outstanding amounts in cash, investors receive shares at discounted prices.
CLNs make sense for companies as well. The funding process can be a long one, and that might not work for entrepreneurs that need cash quickly.
However, CLNs can be issued quickly and without a great expense to the founders, and they make the most sense when the company needs to seize on time-sensitive opportunities.
Why CLNs are a good alternative for investors in 2021
For many founders, the new normal has brought with it bridge rounds and emergency fundraisings. As investors become more cautious during a recession, the less risky nature of CLNs makes for a good alternative to traditional equity investment.
Due to the current economic situation, investors can opt for secured CLNs or debenture agreements. As the name suggests, the debt is secured against assets or intellectual property rights.
Unsecured CLNs, the most common type of convertible loan note, come with discounted conversion rates on shares.
CLNs rely on valuation caps on converting balance. Since the pandemic has led to lower valuations and limited cash flows, investors can get shares at a discount that wouldn’t otherwise be available to them.
With a typical CLN structure, investors are in for at least a 20% discount on the valuation at the next round of funding. They may ask for high rates of interest, which can then also be converted to shares at a discount.
If the company fails or doesn’t reach its funding target, the investor is treated as a creditor. The investment and interest have to be repaid in full, and the loan takes precedence in the event of a liquidation.
If further reassurance is needed, the investor may ask for extra warranties from the company, as well and veto and pre-emption rights and the option to observe votes on the board.
For investors looking for CLN opportunities, Envestors and CQRS would like to introduce you to our latest offering, Tespack.
Tespack, who designs, builds and patents mobile energy storage solutions, are doing their pre-IPO fundraise and would be a great opportunity for any investor looking or CLNs.
(*Capital at risk)