The convertible note we signed without doing the maths

The pitch for a convertible note is genuinely attractive when you are tired. You need money now, you do not want to argue about what the company is worth today, so you take the cash as a loan that turns into shares at the next proper round — at a discount, to reward the person who went early. Nobody has to agree a valuation. The paperwork is short. The money can land in a fortnight.

We took £150,000 that way, with a 20% discount, a £2 million valuation cap, 8% interest and a twelve-month longstop date. I read the document. I understood every clause individually. What I never did was open a spreadsheet and work out what those four numbers would do together at a plausible next round, which is the only exercise that would have told me anything useful.

What a convertible note is, in one paragraph

A convertible loan note is debt that converts into equity on a trigger event, usually the next qualifying equity round. Until it converts it is a loan, it usually carries interest, and it sits on your balance sheet as a liability. If no round happens by the longstop date, what happens next depends entirely on what the document says: conversion at a set valuation, an extension, or repayment. That last option is the one founders skim past, and it is the one that can put a company into a genuine crisis.

The two numbers that do all the work

The discount is straightforward. A 20% discount means the note holder pays 80% of whatever the new investors pay per share.

The cap is not straightforward, and it is where the money actually moves. A valuation cap sets a maximum valuation at which the note converts, however well the round goes. Its purpose is fair enough — the early money took the risk before there was a price, so it should not be punished if the company does brilliantly in the meantime. Its effect, when the round comes in well above the cap, is that the note converts at a price bearing no relation to what anyone else is paying.

The conversion price is the lower of the discounted round price and the cap price. Not the average. The lower.

A discount is a thank-you. A cap is a bet on how well you do between now and the round — and you are on the other side of it.

The maths I should have done before signing

Illustrative figures, but the mechanics are exact.

Before the note, the company has 1,000,000 shares. Fourteen months later we raise £1,000,000 at £4.00 a share, which values the business at £4 million pre-money and issues 250,000 new shares.

The note is £150,000 plus 8% interest accrued over fourteen months, roughly £14,000, so £164,000 converts.

Apply the 20% discount to the round price and you get £3.20 a share. Apply the cap instead: £2 million across 1,000,000 shares is £2.00 a share. The lower price wins, so the note converts at £2.00, and £164,000 buys 82,000 shares.

At the round price of £4.00 the same money would have bought 41,000 shares. At the discounted price it would have bought 51,250. The cap doubled the holding.

Follow it through. Total shares after the round: 1,000,000 plus 250,000 plus 82,000, which is 1,332,000. The note holder ends up with 6.2% of the company for £150,000, at a moment when new investors are paying £1,000,000 for 18.8%. The founders, who held 700,000 shares, go from 70% to 52.6%.

None of that was unfair. Every number was in the document I signed. It was simply a materially different deal from the one I thought I had agreed, and the gap between the two was a cap I had treated as a formality.

The tax point nobody mentioned

The second thing I did not know is the one that cost us relationships rather than percentages.

Convertible loan notes do not qualify for SEIS or EIS relief. The investment is a loan, and the schemes require a subscription for new ordinary shares. Two of the angels who put money into that note had assumed — as had I — that because they were funding an early-stage UK company, the relief would follow. It did not, and explaining that after the event is a conversation I would not like to repeat.

The instrument that does work is an advance subscription agreement. An ASA is not a loan: it is money paid now to subscribe for shares later, and because it can never be repaid in cash it can qualify for SEIS or EIS. HMRC's conditions are specific and unforgiving. The subscription cannot be refundable under any circumstances. It cannot carry interest. It cannot be varied, cancelled or assigned. It cannot come with investor protections. And the longstop date — the date by which it must convert if no round has happened — cannot be more than six months from the date of the agreement.

That six-month limit is the real trade-off. An ASA gives your investors a shot at 50% or 30% income tax relief and gives you no debt on the balance sheet. It also gives you six months to get a priced round done, where a note might have given you eighteen. Which of those two things is worth more depends entirely on how close your round actually is, and founders are famously optimistic about that.

Would I use one again?

Yes, in one situation: a genuine bridge, where a priced round is close to certain and close in time, and the alternative is spending two months negotiating a valuation for money you need in three weeks. That is what the instrument is for, and used that way it is excellent. The same logic applies to bridging generally — and it is worth knowing what a bridge round can cost when the next round doesn't arrive before you assume the runway maths works.

No, in two others. Not when your investor base is made up of individuals expecting SEIS or EIS relief, because a note quietly removes something they were counting on. And not as a way of avoiding a valuation conversation you do not want to have — that conversation does not disappear, it just gets postponed to a moment when you have less leverage and a longstop date approaching. If the real problem is that you cannot defend your number, the answer is working out what the company is genuinely worth rather than deferring it.

What I would insist on now

Model it at three round prices before signing. A pessimistic one, a realistic one and a good one. If the good outcome makes the note holder's stake look absurd, your cap is wrong. This takes half an hour in a spreadsheet.

Understand what happens at the longstop date, in writing, in plain words. Automatic conversion at a stated valuation is survivable. Repayable on demand, when the whole reason you took the note was that you had no cash, is not.

Ask whether interest accrues and converts. Ours did. Fourteen months of 8% added £14,000 of conversion value that nobody discussed at the time.

Check the qualifying round threshold. If conversion is only triggered by a round above a certain size, a smaller round leaves the note sitting there as debt, and the next investor has to decide what to do about it.

Tell your investors, before they wire anything, that a note is not SEIS or EIS eligible. If that matters to them, use an ASA and accept the six-month clock.

Three years on the company is fine, the note holder has been a good shareholder, and I still think taking that money was the right call. What was wrong was signing four numbers I had not multiplied together. Half an hour with a spreadsheet, before the meeting where everyone is relieved the money is coming, is the cheapest work a founder ever does — and much the same discipline applies to everything else in a term sheet.

Common questions

What is the difference between a convertible loan note and an advance subscription agreement?

A convertible loan note is debt. It sits on the balance sheet as a liability, usually carries interest, and converts to shares on a trigger event — or, depending on the wording, may be repayable if no round happens. An advance subscription agreement is money paid now to subscribe for shares later and can never be repaid in cash, which is precisely why it can qualify for SEIS or EIS relief where a note cannot. The trade-off is time: HMRC requires an ASA to have a longstop date no more than six months away, while a note can run for a year or longer.

Can investors claim SEIS or EIS relief on a convertible loan note?

No. SEIS and EIS require a subscription for new ordinary shares, and a convertible loan note is a loan at the point the money is paid, so the investment does not qualify. This catches out angel investors regularly, because the company itself may be perfectly SEIS or EIS eligible. If relief matters to your investors, use an advance subscription agreement instead, which HMRC accepts provided the money is non-refundable in all circumstances, carries no interest, cannot be varied, cancelled or assigned, carries no investor protections, and converts within six months. Tell investors which instrument they are signing before they transfer money.

What does a valuation cap actually do?

A cap sets a maximum valuation at which the note converts, regardless of what the next round is priced at. The conversion price is the lower of the discounted round price and the cap price, so when a round comes in well above the cap, the cap decides the outcome and the discount becomes irrelevant. On a £150,000 note with a £2 million cap and 1,000,000 shares in issue, conversion happens at £2.00 a share even if new investors are paying £4.00 — buying twice the shares a straight 20% discount would have. Model the cap against an optimistic round price before agreeing it.

What happens if no funding round happens before the longstop date?

Whatever the document says, which is why it is the clause to read first. Common outcomes are automatic conversion at a stated valuation, an extension by agreement, or repayment of the loan with accrued interest. The last is the dangerous one: a company that took convertible money because it had no cash is rarely in a position to repay it twelve months later, and a demand at that point can be existential. Before signing, get the longstop mechanism explained in plain words, and make sure automatic conversion at a defined price is the default rather than something requiring the note holder's goodwill.

Buzz Accounting, a fixed-fee UK accountancy practice, has more on fixed-fee accounting for small businesses.