This article looks at the increased use of Convertible Loan Notes lately, from the point of view of the investor and the borrower – from a team that gets involved on both sides of the fence:
Convertible Loan Note: Debt piece with typical expected protections, however fully convertible into equity (common or other) under certain specified circumstances.
The attraction of Convertible Loan Notes to borrowers….less dilution
Lately a couple of CEOs I’ve worked with in early stage (i.e. pre-revenue start-ups) have asked me about the virtues of raising capital via Convertible Loan Notes (hereafter CLNs) as opposed to straight or even preferred equity. Their premise and desire to do so is quite simple – avoid dilution now at the current valuation and have the conversion occur at a time when they feel a higher valuation will be warranted.
Obviously these CEOs have a lot of confidence in their company’s prospects – they have to or they would not have started in the first place. However I urged them to tread carefully for reasons we will go into. Having a debt instrument on the balance sheet with a termination date (however long-dated) in a company with no cash flow can be a dangerous game to play and I have seen this first hand seriously backlash against original equity holders when things don’t go according to plan. As for the investors in CLNs – It’s always nice to have your cake and eat it – as long as you are not spoiling the cake for the next investors…
Or maybe there is no other option but a CLN….
Another company took on CLNs for the exact opposite reason. The company was running out of cash in a few weeks and current investors were losing confidence in the business plan or cash flow projection and their own ability to price the company at that time (alternative approach being to do a total whitewash/recap of the business). Hence without taking this nuclear option, investors wanted the most protection they could achieve with an investment instrument however with the full upside maintained. Again this solution may also not have been optimal as we found out in the medium term to our detriment as a company and CLN investors. A total renegotiation of the original CLN terms ensued, as required by an incoming investor who felt they were too harsh on the original shareholders.
To analyse the above scenarios – let’s first look at where a CLN can sit in the capital structure. Due to the “Convertible” element of this debt form it can essentially sit anywhere in the below charted spectrum of returns and essentially switch places at will to suit the investor generally. It can be an extremely powerful instrument with protective negative covenants/vetoes and controls associated with it. Next we will look at what those key terms could be.
The spectrum of capital instruments in a company – CLN can essentially sit ANYWHERE below:
*Preferred equity sits above common mainly due to the preferred return or liquidation pref which may be part of it – a convertible preferred of course can “double dip” –take a preferred return (typically 1-2X) and then convert to common and share equally in the remaining proceeds.
What is it exactly? It’s whatever you want it to be….or don’t want it to be….
At its most basic a CLN is piece of debt which may convert into equity if certain events (normally to the upside for the company i.e. sale, IPO, up-round) come to pass. However, and here is the important bit – the terms around when it may convert can be many and varied i.e. on a qualifying up-round size and price; on a liquidity event – sale or IPO; conversion compulsory or at the note holder’s option; conversion into which equity instrument… etc. Alongside that is the real negotiation point – the conversion price, typically at a discount to the next round (which can be damaging which we shall see later) or a specified uplift price above the deemed current valuation.
Typical terms and what is important to consider:
So after all that – when are they used and the purpose?
Coming from the opening paragraph – In my experience CLNs are generally used in three situations:
- Disaster Situations/Bridge Rounds: Company is running out of capital and current investors want to put in a bridge/emergency capital to get to a larger round. Most likely the company is at turnaround status at this point i.e the company is struggling badly to execute on it original plan.
What to look for:
Investors: Obviously need to protect your last capital in, however watch that your terms are not so harsh that the next incoming investor has no choice but to renegotiate these before doing a deal. An example may be: a CLN comes in with a term dictating that when it converts it is more senior to the next incoming instrument – not nice for new money. Effectively by not having a cram-down round at this point in-time you have left current investors who do not follow in the CLN alive to fight another day (depending on how you adjust their voting rights). You can then be faced with a potential new investor insisting you change terms or they won’t invest, leaving you with the choice of liquidation or cave in on your original terms.
Company: Try to resist terms that are too punitive or complicated as it could put off new money. A cram down round can often be better to clean up the cap table for a restart with supportive shareholders. Also the amount: better to get enough to give a decent runway – at least 9 months and an amount which won’t skew the behaviour of the team to pure cost-cutting instead of growth – only growth will get your out of this hole.
- Avoiding dilution for early stage companies – Founders decide to take on a CLN to avoid dilution as they feel valuation inflection points are imminent. Be wary of putting an instrument in your business simply because you do not like the valuation at that point in time. Face the reality and price the company if you can. What you feel may be a valuation inflection point in the very near future may not be shared by professional investors unless it is a hard metric such as sales/EBITDA. Also again it skews the rewards of the next investors versus the investors before the CLN. Please see here this brilliant article from Early Stage Partners which can explain it a lot better than I can – the maths in this article deserve study.
What to look for:
Investors: As seen from the article referenced above (to summarise the article – 1.by putting in an instrument at a discount to the next round, then in a wind-up situation you are penalising the new investors and in an upside case the same; 2. warrants are often a better solution than using a discount – as warrants penalise the existing shareholders in an upside situation and are powerless in a liquidation/wind-up)
Company: Be very clear on the default terms and what happens on maturity for the CLN you are taking on. As a loan at some point it will need to be repaid (if not converted) and as an early stage company with no cash flow – this is not a situation you need to be facing even if the instrument is long-dated. Wirth reference to my statement in the opening paragraph – I have seen a company confident in its growth prospects take on such a CLN instrument then struggle to achieve their own targets and for a relatively small amount of funding had the CLN tail wagging the dog for five years. Careful how you make your bed….
- Later stage companies that cannot get senior debt but don’t want equity dilution – With the lack of bank capital on offer at the moment for growing businesses who are doing well but will struggle with harsh covenants of a senior debt piece – there are funds now setting up issuing CLNs with equity kickers to boost the debt like returns for investors. For the company they are a senior instrument but without the strict covenants and default provision of typical senior debt – i.e. ratio analysis monthly etc. allowing them to grow the pie without immediate dilution or default risks.
What to look for:
Investors: If a company accepts an instrument that is effectively preferred equity but with protective provisions – set to convert at the current valuation of the company – well then they are either extremely confident in their growth plans or really need funds and can’t get any other offers. A company that pushes back on the equity kicker/conversion price is most likely a better prospect on the risk/return graph.
Company: Be certain that you can handle the covenants on any pay current element of the loan – ideally this would be based on a solid recurring revenue stream. A simple cure can be a rollover to a PIK (Payment in Kind) type instrument if the cash element becomes too much to bear. Again the conversion price – where this is set is determined by your negotiating position in terms of a. the growth opportunity this capital will unlock – how big the pie can get, and b. access to cheaper capital.
Conclusion – the terms, the terms, the terms
Depending on the terms associated with it – this instrument can be the most powerful on your balance sheet or the kindest. So when should you use a CLN?
In my opinion only in two situations 1. if you are in an extreme position and running out of cash and do not have much negotiating power or 2. if you cannot get bank debt on covenants you are happy with but need capital to finance growth you are confident in – then CLNs can work for you or may be your best option. Taking a CLN which converts at the current valuation sometime in the future at the request of the holder – is just equity with extreme downside protections – so call it how it is. Taking a CLN into an early stage business at a discount to the next round just because you are trying to avoid dilution right now is, in my opinion, just passing the buck on valuation in my opinion at the expense of having a debt instrument which could have to be repaid on your balance sheet. It also transfers negotiating power to the CLN holders vis a vis new equity. It could come back to bite down the line.
To get some templates of typical CLN term sheets to suit your needs feel free to email me Jrowland@whitelake-group.com
Author: John Rowland, Managing Partner
Thanks for input from Ashok Parekh.