In May, the UK Government's £250 million Future Fund was launched to provide financial support to established start-ups and early stage tech companies during COVID-19.

The funding is invested by way of a convertible loan; such loans tend to be popular with early stage companies, and like any other type of investment funding, have pros and cons that founders should be aware of.

What is a convertible loan?

It's a type of loan that is either repaid or, more commonly, converted into shares at a future date. Ordinarily, raising convertible loan funding is less time consuming and costly than completing an equity funding round

and provides quick access to cash, often in anticipation of an equity funding round completing at a later date.

Like any commercial loan (and particularly because the loan is capable of converting to shares), there are key terms to be agreed by the investor – the individual or party providing the convertible loan - and investee company.

When is the loan convertible?

The investor and the investee company will negotiate a ‘trigger’ for converting the loan into shares; typically an agreed date or a qualifying round of equity funding.

Other common triggers include default, change of control and the sale or liquidation of the company.

The amount of funding to be raised before a round constitutes as qualifying has to be agreed by the company and investor – and will likely involve a degree of compromise.

The investor will want the threshold amount to be high enough to ensure that, if the loan does convert to shares, those shares are in a company which is promising and sufficiently funded. The investee company will want that amount to be realistic and achievable.

What will be the price per share on a conversion?

The parties should consider the conversion price and the class of shares on conversion. The loan will normally convert at an agreed price or, more commonly, at a discount against the price achieved per share in the qualifying round of funding.

In terms of the class of shares, the loan investor will usually subscribe for the most senior class issued in the funding round when the loan converts.

The investor may also insist on a valuation cap, to provide protection if the investee company’s valuation suddenly increases.

The loan would still convert to shares at the trigger event (i.e. the qualifying round or specific date) but at a different price, based on the cap.

Parties should be aware that a convertible loan may bear interest. However, the investee company may look to negotiate a position whereby the loan only accrues interest if it is redeemed, rather than converted into shares.

They may also seek to defer interest payments under the convertible loan as a means of protecting cash.

Pros and cons for investee companies

For an investee company, the advantages of a convertible loan include:

  • raising cash quickly in the early stages;
  • deferring a company’s valuation, allowing time for an increase in share price and reducing the amount of equity the company gives away at a lower share price; and
  • greater control for existing founders and shareholders. The investor would ordinarily seek minimal rights as a lender, with additional shareholder rights granted only upon conversion of the loan into shares.

Disadvantages include:

  • convertible loan funding does not qualify for Enterprise Investment Scheme or Seed Enterprise Investment Scheme relief (and is, therefore, not as attractive for investors);
  • any valuation cap or conversion price mechanism needs to be documented at the outset, which involves time and money; and
  • if the investor receives a large discount on the price paid for shares on a qualifying funding round, this may affect the company's valuation in future rounds, as new investors will not want to pay a much higher price.

There are also pros and cons for investors – if the company fares well and raises investment, for example, the investor can subscribe for shares at a discounted price. Conversely, they have few rights prior to conversion of the loan.

There is no one-size-fits-all solution for companies seeking investment, so it's critical to weigh up all the pros and cons and consider the specifics of your business before choosing the convertible loan option.

Richard Murdoch is a senior solicitor in Brodies' corporate practice.

This article first appeared in The Scotsman