Convertible Loan Notes: How Startups Can Use Them to Bridge Funding Gaps

Startups often face the challenge of bridging funding gaps between equity rounds. During these periods, they need to secure additional capital without immediately diluting their ownership. Convertible loan notes offer a flexible and strategic solution to this problem. In this blog, we will explore how convertible loan notes can be an effective tool for startups to bridge funding gaps, and provide examples and case studies of startups that have successfully used this method.

Understanding Convertible Loan Notes

Convertible loan notes are a type of short-term loan that converts into equity, typically during a future financing round. Essentially, investors lend money to a startup with the expectation that the loan will be converted into shares later, usually at a discounted rate to the price of the new equity round. This mechanism allows startups to secure immediate funding while delaying equity dilution.

How Convertible Loan Notes Work

1. Issuance: Startups issue convertible loan notes to investors, agreeing on the terms such as interest rate, maturity date, and conversion discount.
   

2. Accrual: The loan accrues interest until it either reaches maturity or is converted into equity.
   

3. Conversion: At a predefined event, usually the next equity financing round, the loan converts into equity at a discount to the new round's price.

Advantages of Convertible Loan Notes

1. Delayed Dilution: Startups can raise funds without immediate dilution of ownership, allowing founders to retain more control until a later stage.
   

2. Speed and Flexibility: Issuing convertible loan is typically faster and more flexible than an equity round, as it involves simpler documentation and fewer negotiations.
   

3. Attractive to Investors: Investors benefit from the potential upside of equity conversion at a discounted rate, making convertible loan notes an appealing option.

When to Use Convertible Loan Notes

1. Between Equity Rounds: Convertible loan is ideal for bridging the gap between equity rounds, providing the necessary capital to reach key milestones or improve valuation.
   

2. Testing Market/Product: When startups need quick funds to test the market or further develop a product before seeking a larger equity round.
   

3. Unexpected Opportunities: When unexpected opportunities arise that require immediate funding, convertible loan allows startups to act quickly without undergoing a full equity round.

Case Studies of Successful Use of Convertible Loan Notes

Case Study 1: ApTap

ApTap, a UK-based fintech and Pinnacle Global Advisory client, used convertible loan notes to bridge a funding gap during its early stages. During its Seed funding round, ApTap issued convertible loan notes to secure quick capital for scaling its operations while institutional investors complete their due diligence. This approach gave ApTap the necessary working capital to support their operations, therefore allowing them to continue scaling their business while they complete negotiations with VCs for their subsequent equity round.

Case Study 2: Angara Global

Angara, another client of Pinnacle Global Advisory, leveraged convertible loan notes to fund its growth between equity rounds. By issuing convertible loan notes, Angara has financed its expansion into new markets and enhance its platform features and suite of services. This strategic use of convertible loan helped Angara maintain momentum with the objective of attracting a larger investment in future rounds at a much valuation.

Practical Advice for Startups Considering Convertible Loan Notes

1. Negotiate Terms Wisely: Carefully negotiate the terms of the convertible loan notes, including the conversion discount, interest rate, and maturity date. Ensure these terms align with your startup’s growth plans and future financing goals.
   

2. Prepare for Conversion: Plan for the eventual conversion of loan to equity by maintaining clear and transparent financial records. This will facilitate a smooth transition during the next equity round.
   

3. Communicate with Investors: Keep open lines of communication with your investors about the use and impact of convertible loan. Transparency helps build trust and ensures alignment with your long-term vision.
   

4. Monitor Cash Flow: Be mindful of cash flow management, as convertible loan involves regular interest payments until conversion. Ensure your startup can comfortably meet these obligations.
   

5. Consider Legal and Tax Implications: Consult with legal and financial advisors to understand the legal and tax implications of issuing convertible loan notes, ensuring compliance with all regulations.

Convertible loan notes are a valuable tool for startups looking to bridge funding gaps between equity rounds. By offering a flexible and non-dilutive source of capital, they enable startups to reach critical milestones, test markets, and seize unexpected opportunities. Through careful planning and strategic use, convertible loan notes can help startups achieve their growth objectives and secure more favourable terms in future equity rounds.

For startups considering convertible loans as part of their fundraising strategy, Pinnacle Global Advisory provides expert guidance and support, helping you evaluate and implement this financing option. Contact us today to learn more about how we can assist your startup in making informed financing decisions.