Convertible loan notes: the terms founders need to understand before signing

What a convertible loan note actually is

A convertible loan note (CLN) is a loan. An investor gives a company cash now, the company records it as a liability, and instead of being repaid in cash the loan is designed to convert into equity, usually at the company’s next priced funding round. Until it converts, it sits on the balance sheet as debt, not equity, which is the key legal difference between a CLN and a SAFE or an ordinary share subscription.

Because it is debt, a CLN normally carries a maturity date, and often an interest rate too. If the company has not raised a qualifying round by the maturity date, the note does not just disappear. Depending on what was agreed, the investor may be able to demand repayment, force a conversion at a pre-agreed valuation, or negotiate an extension. This is the single most important thing for founders to understand: a CLN is not free money sitting quietly until things go well. It is a liability with a deadline attached.

When founders actually use one

CLNs tend to appear in situations where a full priced equity round is not practical or not yet justified. Common examples include a short bridge between two larger rounds, a top-up from existing investors to extend runway while the company hits a milestone, or an initial injection from angels or a founder’s network before the company is ready for formal valuation negotiations. They are also used when speed matters: a note can be documented and signed far faster than a priced round, which involves agreeing a valuation, updating the cap table, and issuing new share classes.

The trade-off is that a CLN defers the hard conversation about valuation rather than avoiding it. At some point the note has to convert, and the terms of that conversion determine how much of the company the noteholder ends up owning.

The terms that decide the outcome

Four mechanics matter more than anything else in a CLN.

Discount rate. This gives the noteholder a percentage reduction on the price per share paid by investors in the next priced round, rewarding them for taking risk earlier. A discount of this kind is standard, but the exact percentage varies deal by deal and should be checked against current market norms rather than assumed.

Valuation cap. This sets a ceiling on the valuation used to calculate the conversion price, regardless of what the next round is priced at. If the company grows quickly and the next round comes in well above the cap, the noteholder still converts as if the valuation were the capped figure, meaning they get more shares for their money than new investors in that round. Founders should model what a cap actually does to the cap table before agreeing to one, because it can materially increase dilution if the company performs well.

Interest. Many notes accrue interest, which is typically added to the principal and also converts into shares rather than being paid in cash. This quietly increases the number of shares the noteholder receives at conversion, so it is worth checking whether interest is simple or compounding and how it is treated on conversion or repayment.

Maturity and what happens if there is no round. This is the clause founders most often overlook. A well-drafted note sets out clearly what happens if no qualifying financing round occurs before maturity, whether that is automatic conversion at a fixed valuation, extension by mutual agreement, or repayment on demand. A poorly drafted note can leave a company facing a repayment demand it cannot afford at exactly the moment cash is tightest.

Why investors like them and what founders should watch for

For investors, a CLN offers downside protection that pure equity does not: if the company fails before conversion, the noteholder is a creditor, ranking ahead of shareholders in any wind-down, rather than simply losing their equity stake. For founders, the appeal is speed and flexibility, but that convenience comes with real obligations attached to a fixed timeline.

Before signing, founders should get clarity on what triggers conversion, what happens on maturity if no round has taken place, how the discount and cap interact if both are present, whether interest is payable in cash or shares, and whether the note holder has any consent rights over the company’s actions in the meantime, such as taking on further debt. These terms should be checked against current market standards through a solicitor experienced in venture financing, since acceptable ranges shift over time and vary by stage and sector.

Getting the paperwork right

A convertible loan note is a legal debt instrument, and getting the drafting wrong can create real cash flow risk months or years after the money has been spent. Founders should use a solicitor to draft or review the note, keep a clear record of all outstanding notes and their terms on the cap table from day one, and model conversion scenarios at different future valuations before agreeing to a cap or discount. The Law Society directory can help founders find a solicitor with relevant startup finance experience, and general guidance on business finance options is available through the British Business Bank.