Convertible Loan Notes: Structure, SEIS/EIS Implications and Dilution for UK Startups

Understanding Convertible Loan Notes for UK Startups

For UK founders in the pre-seed or seed stage, fundraising conversations often hit a familiar impasse: you need capital to grow, but setting a concrete valuation feels premature. Convertible instruments are designed to solve this by deferring the valuation discussion, allowing you to secure funding quickly. However, choosing the right instrument in the UK is more complex than it first appears. Understanding the fundamental differences between a Convertible Loan Note (CLN) and an Advance Subscription Agreement (ASA) is essential. Making the wrong choice can have significant consequences for future funding rounds, founder dilution, and critically, your investors’ ability to claim valuable tax reliefs. This guide explains how do convertible loan notes work for UK startups, focusing on the practical decisions you need to make to protect your company and your investors.

The Foundational Concept: A CLN is a Loan

At its core, a CLN is a loan. An investor lends your startup money, and in return, you promise to repay it with interest at a future date, known as the maturity date. The unique feature is the “conversion” element: instead of being repaid in cash, the loan is designed to convert into equity during a future priced funding round. The trade-off is clear: speed for valuation ambiguity. You get cash in the bank without having to agree on a valuation today, and the investor gets a debt instrument that they hope will become valuable equity later.

This structure offers a simple way to get a deal done, but its identity as debt is its defining characteristic. This has direct implications. First, it accrues interest, which adds to the total amount that will eventually convert into shares, increasing dilution. Second, if the company fails to raise a subsequent funding round before the maturity date, the noteholders could theoretically demand repayment in cash. This creates a significant financial risk for an early-stage venture that is likely not yet profitable. The CLN is one of the most common startup fundraising instruments UK founders consider, but it requires careful thought.

The Critical First Decision: CLN vs ASA for SEIS/EIS Eligibility

This is the first and most critical filter for UK founders. The decision between a CLN and an Advance Subscription Agreement (ASA) often comes down to one thing: tax relief. Understanding the convertible loan note tax treatment UK regulations dictate is non-negotiable, as it directly impacts your ability to attract angel investment.

Why a Standard CLN is Not SEIS/EIS Compatible

A standard Convertible Loan Note (CLN) is not compatible with SEIS/EIS tax relief schemes in the UK. The reason is rooted in how HMRC defines a qualifying investment. According to HMRC SEIS/EIS Manuals, investment must be for new shares and carry the 'risk of the venture'. A CLN is considered debt and is therefore ineligible. The key is the phrase 'at-risk capital'; because a CLN includes a provision for repayment in cash, HMRC does not see the capital as fully at risk. This makes it an unsuitable instrument for investors who rely on these reliefs.

The ASA: The SEIS/EIS-Compliant Alternative

This is where the Advance Subscription Agreement (ASA) becomes essential. An Advance Subscription Agreement (ASA) is structured as an advance payment for equity, not a loan, to align with HMRC's 'at-risk capital' requirement for SEIS/EIS. This distinction is not just academic; it changes the instrument's fundamental nature. To comply with these rules, ASAs do not have an interest rate or a strict repayment provision at maturity. Instead of repayment, an ASA must convert into equity, typically at a pre-agreed longstop valuation if a qualifying funding round does not occur.

Making the Choice

For founders targeting UK-based angel investors, for whom SEIS/EIS relief is a primary motivator, the ASA is almost always the correct choice. If your investors are primarily venture capital funds, international investors, or others who are not eligible for or concerned with SEIS/EIS, a CLN remains a viable option. For a deeper look at the tax mechanics, see our guide on SEIS and EIS Funding for UK Startups.

• SEIS/EIS Eligibility: An ASA is eligible; a CLN is not.
• Instrument Nature: An ASA is an advance payment for equity. A CLN is debt that converts to equity.
• Interest: An ASA does not bear interest. A CLN typically accrues interest at 4-8% per annum.
• Maturity Event: An ASA must convert into equity. On a CLN, the investor can demand cash repayment.
• Primary Use Case: ASAs are for SEIS/EIS-seeking UK angel investors. CLNs are for VCs and other non-SEIS/EIS investors.

Negotiating the Core Terms of Your Convertible Instrument

Once you have selected the right instrument, you must negotiate its key commercial terms. These levers determine how much of your company you are giving away and under what conditions. While every term is negotiable, the reality for most pre-seed startups is more pragmatic: you are often negotiating against established market standards. Understanding these standards is key to securing a fair deal.

1. Valuation Cap

The valuation cap sets the maximum valuation at which the investor’s money converts into equity. This protects early investors from a scenario where your valuation soars in the next round, which would otherwise diminish their future equity stake. If the next round’s valuation is higher than the cap, they convert at the cap. If it is lower, they convert at the round valuation, often with a discount. A 'pre-money' valuation cap is the standard in the UK for convertible instruments. This is a key difference from the US, where post-money caps (popularised by Y-Combinator's SAFE notes) are more common. A pre-money cap is generally more founder-friendly as it is less dilutive. For more detail on modelling, read our Advanced SAFE Terms guide.

2. Discount

The discount gives the investor a percentage reduction on the price per share paid by new investors in the next funding round. It serves as a reward for taking an earlier risk on your business. A standard market discount for convertible instruments is 10-20%. Typically, the investor gets the benefit of either the valuation cap or the discount, whichever results in a lower price per share and thus more equity. This is a crucial area of negotiation for investor protections convertible notes are known for. For a comparison with US practice, see our guide on SAFE vs Convertible Notes for US Startups.

3. Interest Rate (CLN Only)

Since a CLN is a loan, it accrues interest. This interest is added to the principal investment, and the total amount converts to equity. Common interest rates for CLNs are 4-8% per annum. While it may seem like a small amount, this interest compounds the total sum converting into shares and adds to the overall dilution. As a founder, you should aim for the lower end of this range during negotiations.

4. Maturity Date

This is the deadline by which a conversion event, such as a qualifying funding round, must happen. A typical maturity date for a convertible instrument is 12-24 months. For a CLN, this date represents a significant risk; if no funding round occurs, the investor can demand cash repayment. For an ASA, this date triggers a mandatory conversion into equity at a pre-agreed longstop price, providing more certainty for the company. These convertible note legal requirements must be clearly defined in the agreement to avoid future disputes.

Understanding How the Equity Conversion Process Works for UK Startups

An instrument is only as good as the clarity of its conversion terms. Founders must plan for the three primary scenarios that trigger the equity conversion process UK startups will face.

1. Qualifying Financing Round

This is the intended and most common outcome. The company raises a new round of funding (e.g., a Seed or Series A round) that meets a minimum threshold defined in the note agreement, for example, “at least £500,000 raised”. This threshold prevents conversion on a small, informal bridge round. At this point, the noteholder’s principal (plus interest for a CLN) automatically converts into the same class of shares issued to the new investors, at a price determined by the valuation cap or discount.

2. Change of Control

If the company is acquired before the note converts, the agreement will specify the outcome. Usually, the noteholder has a choice. They can either receive a cash repayment, often at a premium (e.g., 2x their initial investment), or convert into equity immediately before the sale at the valuation cap to participate in the acquisition proceeds. The premium rewards the investor for their early risk if an exit happens sooner than expected.

3. Maturity

If the maturity date is reached without a qualifying round or an acquisition, the paths for a CLN and ASA diverge significantly. For a CLN, the investor may have the right to demand repayment of their principal and accrued interest. This can put a cash-strapped startup in a very difficult position and may even trigger insolvency. For an ASA, this scenario must trigger conversion into equity. This usually happens at a pre-agreed “floor” valuation, also known as the longstop valuation, which protects both the founder and the investor from an undefined outcome.

Forecasting the Dilution Impact on Your Cap Table

Understanding how do convertible loan notes work for UK startups is incomplete without modelling the dilution. You cannot afford to be surprised by your cap table after a conversion. The only way to prepare is to model every scenario in a simple spreadsheet. This exercise is fundamental when considering convertible loan note vs equity UK fundraising options.

Let’s walk through a synthetic example:

A UK-based Deeptech startup has 1,000,000 existing shares. They raise £200,000 via a CLN with the following terms:

• Valuation Cap: £2,000,000 (pre-money)
• Discount: 20%
• Interest: 8% (we will assume 1 year passes, so £16,000 of interest accrues)

The total amount to convert is £200,000 (principal) + £16,000 (interest) = £216,000.

One year later, the company raises a £1,000,000 Series A at a £5,000,000 pre-money valuation. Now, we calculate the CLN holder's conversion price.

1. Price per Share of the New Round: £5,000,000 valuation / 1,000,000 existing shares = £5.00 per share.
2. Price with Discount: £5.00 x (1 - 0.20) = £4.00 per share.
3. Price at Valuation Cap: £2,000,000 cap / 1,000,000 existing shares = £2.00 per share.

The investor gets the benefit of the better outcome, which is the lowest price. Here, the Valuation Cap provides the lowest price (£2.00).

• Shares Issued to Noteholder: £216,000 (principal + interest) / £2.00 per share = 108,000 shares.
• Shares Issued to New Investors: £1,000,000 / £5.00 per share = 200,000 shares.

The final cap table would look like this:

• Founders/Existing Shareholders: 1,000,000 shares (76.1%)
• CLN Holder: 108,000 shares (8.2%)
• New Series A Investors: 200,000 shares (15.2%)
• Total Shares: 1,318,000

This simplified model shows the concrete impact on founder ownership. Running these calculations helps you understand the true cost of the capital you are raising.

Practical Takeaways for Founders

Navigating the early stage funding options UK startups have available can be complex, but a few principles can provide clarity. First, the SEIS/EIS question is your primary filter. If your angel investors require this tax relief, an ASA is your only viable path for a convertible instrument. This decision simplifies many subsequent terms, removing interest and the risk of repayment at maturity.

Second, never sign a term sheet without modelling the potential dilution. Use a spreadsheet to test how the valuation cap and discount affect your ownership under different future financing scenarios. What seems like a small percentage point difference now can represent significant value later on. The reality for most pre-seed startups is more pragmatic, but you must understand the mechanics of the deal you are signing.

Finally, while speed is a benefit of convertible notes, it should not come at the cost of clarity. Ensure the definitions for a “Qualifying Financing Round” and the procedures at maturity are unambiguous. For founders leading finance without a dedicated CFO, taking the time to understand these mechanics is not just good practice; it is essential for the long-term health of your company and your relationship with your earliest backers. Ensure all agreements comply with the Companies Act share-allotment rules. Clarity over speed is the safer path.

Frequently Asked Questions

Q: Can a Convertible Loan Note ever be eligible for SEIS/EIS tax relief?
A: No, a standard CLN is structured as debt and is therefore ineligible for SEIS/EIS relief under HMRC rules, which require capital to be fully 'at risk'. The Advance Subscription Agreement (ASA) was specifically designed as a compliant alternative, functioning as an advance payment for equity without a repayment clause.

Q: What happens if my startup cannot pay back a CLN at maturity?
A: If a CLN matures without a funding round, the investor can legally demand repayment of the principal plus accrued interest. For a cash-constrained startup, this can lead to difficult negotiations, a potential default, or even insolvency. Often, founders will try to negotiate an extension of the maturity date or conversion at a floor valuation.

Q: Which is better for a founder: a high valuation cap or a low discount?
A: It depends on the valuation of the next funding round. Generally, founders prefer a higher valuation cap and a lower discount, as both limit dilution. A high cap protects founder equity in a high-growth scenario, while a low discount reduces the 'bonus' shares an investor receives in a lower-valuation round.

Q: Why is a pre-money valuation cap standard in the UK for convertibles?
A: The pre-money cap has historically been the market standard in the UK and is often perceived as more founder-friendly because it provides greater certainty about the dilution from the converting note. Post-money caps, common with US SAFE notes, can create more complex dilution scenarios, especially when multiple notes are issued.