Convertible Loan Notes Explained: UK Startup Guide

A convertible loan note is a short‑term debt instrument that converts into equity at a future funding round or another agreed-upon trigger event. Founders often use this instrument because it allows them to raise capital quickly while deferring a formal company valuation. In the UK, the decision is not just about how the note works; it also involves choosing between a convertible loan note, an Advance Subscription Agreement (ASA) or a SAFE. Each choice affects your cap table, potential dilution, SEIS/EIS eligibility and future investor negotiations.

This guide explains how convertible loan notes work in practice, highlights key terms and common pitfalls, compares them to ASAs and SAFEs, and shows you when each might be the right choice for your growing startup.

What is a convertible loan note?

A convertible loan note (CLN) is debt issued by a company that gives the investor the option to convert the loan into equity at a later date. This hybrid instrument allows startups to raise funds quickly because the negotiation focuses on debt terms rather than a precise valuation. The note typically includes a discount on the share price and may specify a valuation cap. Below, we unpack what this means in plain English.

Convertible loan note definition in plain English

At its core, a convertible loan note is a short‑term loan that will either be repaid or converted into shares. The company receives cash now, giving it breathing room before a priced equity round. Investors lend money with the expectation that they will later receive shares at a discount to the price paid by new investors. If conversion never occurs, the investor can ask for repayment with interest. The trigger events for conversion are usually defined as:

• Qualified funding round – a future equity round raising at least a specified minimum, at which point the note converts automatically.
• Longstop/maturity date – if no round occurs by a set date, the investor may convert or require repayment.
• Sale or change of control – if the company is sold or undergoes a liquidation event, the note can convert or be repaid.

Because a CLN is debt until conversion, the investor ranks ahead of shareholders in an insolvency and may earn interest. This debt nature differentiates CLNs from ASAs and SAFEs, which are equity‑like and do not accrue interest or have repayment obligations.

How does a convertible loan note work in practice?

When a founder issues a convertible loan note, they enter into a short loan agreement with the investor. The loan amount is paid to the company immediately. The note then accrues interest, usually at a low rate compared with bank debt (often 2–10% per year). Instead of paying cash interest, most notes add the interest to the principal and convert the entire amount into shares on a trigger event. To show how this works, let’s break down the steps.

1. Funding: A startup issues a CLN for £200,000 with a 20% discount and a 3% simple interest rate. The company receives the funds upfront.
2. Accrual: Over 18 months, the note accrues £9,000 of interest (£200,000 × 3% × 1.5 years).
3. Trigger event: A year and a half later, the startup raises a Series A round valuing the company at £2 million (£10 per share). The CLN converts automatically at a 20% discount: the conversion price is £8 per share (20% discount on £10).
4. Conversion: The principal plus accrued interest (£209,000) is divided by £8, so the investor receives 26,125 new shares. If a valuation cap of £1.5 million applied, the effective conversion price would instead be based on that cap (e.g., £7.50 per share), giving the investor more shares.
5. Repayment scenario: If no qualifying round occurs by the maturity date, the investor can request repayment of £209,000 or may agree to convert at a predetermined price.

This example illustrates why founders should model the impact of discounts, caps and interest on their cap table. The discount rewards the investor for early risk but increases dilution. A valuation cap protects the investor if the company grows quickly, potentially leading to more shares being issued. Interest adds to the amount converted. Without careful modelling, founders can be surprised by the number of shares issued when conversion occurs.

What happens at maturity?

Maturity dates are usually set 18–24 months after issuance, though some agreements specify longer periods. If a qualifying round happens before the date, the note converts automatically. If no round occurs, the investor may choose to convert into shares at a negotiated price or demand repayment of the principal plus accrued interest. In practice, founders should avoid reaching maturity without a clear plan: repayment obligations can strain cash flow, and forced conversions can occur at a lower price than desired. Always diary-mature dates and negotiate extensions early.

Key terms founders need to understand before signing

Before issuing a convertible loan note, you should understand the key economic and legal terms. These determine how many shares will be issued, how much interest is owed and whether repayment is required. Neglecting any of these terms can lead to unexpected dilution, unhappy investors or tax issues. Below is a breakdown of the most important concepts.

Valuation cap

A valuation cap sets a maximum company valuation used to calculate the conversion price. If the company’s actual valuation at the next round exceeds the cap, the conversion price is based on the cap rather than the higher valuation. For example, a £1 m cap on a company that raises at a £2 m valuation means the note converts at half the actual valuation, giving investors twice as many shares. Caps protect early investors from being diluted if the company’s value increases rapidly and encourage them to invest before a valuation is set. However, new investors may resist high caps because they imply earlier investors obtain a significant ownership stake; negotiating a reasonable cap is therefore crucial.

Discount rate

The discount rate gives note holders a percentage reduction off the share price paid by new investors when conversion occurs. Typical discounts range from 10–30%, with most deals landing between 15–25%. Where you fall within that range depends on the company's stage, the investor's risk appetite, how long before the next expected round, and prevailing market conditions.

A founder with strong momentum and a short bridge timeline can often negotiate toward the lower end; an investor taking on more uncertainty will push toward the higher end. A discount rewards early investment and compensates investors for the uncertainty of investing before a valuation is fixed. A higher discount means more shares will be issued at conversion, so founders must balance investor incentives with dilution concerns.

Interest and maturity date

Most CLNs accrue interest at a modest rate, often between 2–10% per year, which is usually rolled into the principal and converted into shares rather than paid in cash. The maturity date sets a deadline for conversion or repayment, commonly 18–24 months. Some notes specify a longer “longstop” of up to 36 months. If no conversion has occurred by maturity, the investor may demand repayment of principal and accrued interest or force conversion at an agreed price. The existence of interest and a maturity date differentiates CLNs from ASAs and SAFEs, which typically have no interest or repayment obligations.

Qualifying funding round

The term “qualifying funding round” defines the minimum amount of capital that must be raised for automatic conversion. The threshold is negotiated and should be realistic to balance the interests of the investor and the company. If the threshold is too high, conversion may never be triggered, and repayment becomes more likely. If it is too low, the investor may convert earlier than the company would like. Ensure the threshold reflects the business’s next planned equity raise.

Repayment vs automatic conversion

CLNs are debt until conversion, so repayment obligations remain. If the company fails to raise a qualifying round or reach another trigger, the investor can demand repayment at maturity. Some notes include investor rights allowing conversion at the investor’s election, giving them flexibility to convert early. Repayment is also triggered by events of default, insolvency or breach of covenants. Understanding these provisions helps founders manage cash flow and avoid surprise repayment obligations.

Investor rights

Prior to conversion, note holders usually have limited rights, often restricted to information rights, because they are lenders, not shareholders. Upon conversion, they acquire the same rights as other shareholders, including voting rights and potential board representation. Some investors negotiate covenants or negative control rights that restrict certain corporate actions until conversion. These rights are often standard for larger investments but can reduce flexibility. Founders should examine any restrictive covenants before signing.

When should a UK startup use a convertible loan note?

Convertible loan notes are not a one‑size‑fits‑all solution. The best reason to use a CLN is to bridge funding between equity rounds when speed and flexibility matter more than immediate pricing. Here are common scenarios where a UK founder might choose a convertible loan note:

Common founder scenarios

• Bridge between rounds: You need capital to extend the runway before closing a larger priced equity round. A CLN provides cash quickly without negotiating valuation.
• Pre‑valuation funding: The company has momentum, but metrics are too early to support a meaningful valuation. By deferring the valuation, you avoid setting a low price for your shares and keep more equity.
• Investor demands debt‑style protections: Some investors prefer debt instruments because they carry interest and rank ahead of equity holders if things go wrong. A CLN meets this requirement while still offering potential equity upside.
• Formal bridge for larger sums: When raising more than a modest “friends and family” round, CLNs provide a structured way to document investment. They may require more negotiation than SAFEs or ASAs, but offer clearer terms when multiple investors participate.

In contrast, if your investors expect SEIS/EIS tax relief or you want to avoid debt entirely, an ASA might be a better choice. For very small seed investments, SAFEs offer simplicity but may not be familiar to all UK investors.

Convertible loan note vs ASA vs SAFE

Founders often compare CLNs to ASAs and SAFEs. Each instrument has a different legal status, risk profile and tax implications. The table below summarises the key differences. Keep in mind that, although terms may vary, these are the typical attributes you will encounter.

Which is usually cleaner for UK founders?

Unlike an ASA, a convertible loan note is debt: it usually includes interest and a maturity date, and may need to be repaid if no conversion trigger happens. SAFEs are simpler but originated in the US and may not satisfy UK investor expectations or tax requirements. For UK founders whose investors care about SEIS/EIS relief, an ASA structured to HMRC guidelines is often the cleanest option. When downside protection is more important than tax relief, a CLN can bridge funding quickly while giving investors comfort that their loan will either convert or be repaid.

Are convertible loan notes compatible with SEIS and EIS?

The Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS) provide generous tax reliefs to encourage investment in early‑stage UK companies. Investors qualifying under these schemes receive income tax relief and potential capital gains tax exemptions. However, the instrument used to raise funds must meet HMRC requirements. Traditional CLNs (with interest and the possibility of repayment) generally do not qualify for SEIS/EIS relief. This is because HMRC views loans as debt and requires that qualifying investments be for new shares.

ASAs, when properly structured, are more likely to qualify. An ASA is not a loan, carries no interest, and requires the company to issue shares even if no further funding round occurs. HMRC guidance states that, for the purpose of obtaining advance assurance, the longstop date for an ASA should not exceed six months from the date the agreement is entered into. Where the longstop date is longer, HMRC is unlikely to grant advance assurance. However, a longstop date beyond six months does not automatically disqualify the eventual share issue from SEIS or EIS relief; HMRC has confirmed it will not challenge a claim solely on this basis.

That said, a longer period substantially increases compliance risk, and the simpler and more straightforward the ASA, the better. Founders whose investors need SEIS or EIS relief should treat six months as the working standard and seek specialist tax advice before extending it. A SAFE, being a US instrument, is rarely used in the UK for SEIS/EIS because HMRC has not issued clear guidance, and investors may be wary.

If your investor community values SEIS/EIS relief, the choice of instrument is critical. Many angels will insist on an ASA so they can claim relief. That said, some investors accept the absence of relief in exchange for debt‑style protection. Discuss your investor profile and tax objectives before issuing a CLN.

How convertible loan notes affect your cap table and dilution

Deferring a valuation does not defer dilution. When a convertible loan note converts, the discount, valuation cap and accrued interest can significantly shift ownership percentages. Founders often underestimate this impact. Here’s why modelling matters:

• Discount and cap interplay: A 20% discount combined with a low valuation cap can result in a large number of shares being issued to note holders. For example, a £250,000 note with a 20% discount and £1 m cap could convert into a 25% stake at a £2 m valuation. Without a cap, the stake would be smaller.
• Accrued interest: Even modest interest rates add up. If interest accrues at 5% per year, a two‑year loan increases the amount converted by 10%, further diluting existing shareholders.
• Post‑money option pools: Many funding rounds reserve an option pool for employee stock options. When converting CLNs, remember to factor in the option pool so you don’t give away more equity than intended.
• Multiple instruments: If you issue several notes with different discounts or caps, the conversion mechanics can create a “dilution waterfall” where earlier investors obtain large stakes at different prices. Modelling ensures you understand the combined effect.

Undo Capital’s platform helps founders centralise fundraising workflows, cap‑table management and SEIS/EIS‑related processes. Before signing a note, model scenarios to see how discounts, caps and interest affect your ownership.

Why modelling matters before you sign

Failure to model can lead to unpleasant surprises at conversion. Sprintlaw’s guide warns that founders should run dilution scenarios to align expectations with investors. Cap table modelling also ensures you have the necessary authorities under your articles and shareholder agreements to allot shares when conversion occurs. Taking the time to understand the math protects your stake and avoids disputes during the next funding round.

Common mistakes founders make with convertible loan notes

Convertible loan notes are powerful, but misuse can create problems. Below are common mistakes and how to avoid them:

1. Treating the note as simple equity. A CLN is debt until it converts. Ignoring interest, maturity and repayment obligations can leave you scrambling to repay a loan if no trigger event happens.
2. Ignoring maturity and repayment risk. Failing to diarise the maturity date or plan for conversion can force the company to repay principal plus accrued interest, potentially straining cash flow.
3. Not modelling dilution. Without scenario modelling, founders may be shocked by how many shares will be issued on conversion.
4. Using a CLN when SEIS/EIS expectations point toward an ASA. Traditional CLNs do not qualify for SEIS/EIS relief, so if your investors want tax breaks, an ASA might be better.
5. Signing investor‑friendly language without understanding downside protections. Some notes include restrictive covenants, high interest or penalties. Negotiate terms and seek legal advice before signing.

Light social proof and product bridge

Undo Capital is a cap‑table and fundraising workflow platform that helps UK startups manage convertible instruments, SEIS/EIS compliance and ownership modelling. Our software centralises your cap table, fundraising documents and SEIS/EIS advance assurance processes so you can focus on building your business.

When you’re ready, our platform allows you to model various discount and cap scenarios to see the impact of a convertible loan note before you sign.