Convertible Loan Notes (CLNs) have become a popular instrument for start-ups looking to raise funds, especially now, as some start-ups need to find a quick way to raise funds in between the larger rounds.

They offer a flexible solution for companies that aren’t ready for equity financing but need an injection of capital.

As a finance leader in a start-up, it’s essential to understand how these financial instruments work, their benefits, and the implications for your financial reporting.

What Are Convertible Loan Notes?

A Convertible Loan Note (CLN) is essentially a short-term loan that can later be converted into equity. Unlike traditional debt, the lender doesn’t receive repayments in the form of cash; instead, the loan will convert into shares at a future funding round or an agreed-upon event.

For start-ups, this means immediate access to funds without immediately giving up ownership or dealing with valuation challenges.

CLNs offer flexibility both for start-ups and investors. The note allows start-ups to raise funds quickly, without the pressure of negotiating valuation at an early stage. For investors, it offers the potential to convert into equity at a discounted rate in the future, thus increasing the value of their investment.

What It Means for Start-ups

For start-ups, CLNs provide a tool for fundraising, particularly in the early stages when valuation is uncertain. Since the loan converts into equity later, you can defer discussions around your company’s valuation until your business is in a stronger position. This is particularly advantageous if you expect significant growth in the near term.

CLNs are also favourable because they reduce administrative burden compared to a full equity raise, enabling start-ups to focus on building their business rather than managing complex legal processes.

However, it’s important to consider the terms of the conversion. These include the discount rate, interest rate, and any valuation cap that may be part of the agreement. Understanding these terms is key to ensuring that the financing arrangement is favourable for both the business and its existing shareholders.

Finance Leader Considerations

As a finance leader in a start-up, there are several important aspects to be mindful of when dealing with CLNs:

1. Valuation Cap & Discount Rate: These determine how much equity investors will receive when the loan converts. Be sure to evaluate these terms carefully to avoid over-dilution.

2. Interest Accrual: CLNs often come with an interest rate, which accrues over time. It's important to factor this into your financial forecasting and ensure you account for this additional cost in your cash flow planning.

3. Legal Compliance: Ensure that the terms of the CLN comply with legal and regulatory frameworks. Each region has its own laws governing CLNs and fundraising, so you need to make sure your agreements are watertight.

4. Dilution: Be mindful of how the conversion will impact the current ownership structure. It’s crucial to communicate the potential dilution effect to existing shareholders.

5. Due Diligence: When using CLNs in fundraising, investors will expect detailed financial statements and robust forecasts. Ensure that your accounts are in good order and that you have a plan for how the funds raised through the CLN will be utilised.

How to Account for CLNs in Start-up Finances

From an accounting perspective, Convertible Loan Notes should be recorded as liabilities in the financial statements until they convert into equity. Here’s a high-level overview of how to handle them:

1. Initial Recognition: The loan is treated as a liability, similar to other forms of debt. Record the amount of the loan in the liabilities section of the balance sheet.

2. Interest Accrual: Depending on the terms, you may need to accrue interest on the loan. This should be recorded periodically, and any accrued interest should also be shown as a liability.

3. Conversion to Equity: When the CLN converts to equity (typically during a funding round), the loan and accrued interest are moved from the liabilities section of the balance sheet to the equity section. The corresponding shares are issued to the lender as per the agreement.

4. Disclosure: It’s important to fully disclose the terms of the CLN in your financial statements. Investors and other stakeholders need to be aware of the potential impact of the note on future equity.

Convertible Loan Notes are an excellent way for start-ups to secure funding while deferring the complexities of equity valuation.

However, they come with their own challenges, including the potential for dilution and the need for careful financial planning.

As a finance leader, understanding how to account for CLNs, negotiate favourable terms, and ensure compliance with legal frameworks is crucial for your role in supporting the company’s growth.

Here is how we can work together:

• Join our next FREE Workshop on the FLF Framework.

• Work with me in the Financial Leadership Foundations course  that includes monthly Q&A sessions where we can discuss all of your questions and how to apply your learnings to your current role. 

• Work with me as a Founder needing guidance and support from experienced Finance leaders. Take a look at our guide on Outsourced bookkeeping.