Convertible loan notes and advance subscription agreements, explained
What a convertible actually does, the discount and the cap with arithmetic, why an ASA exists and when to use one, what each does to SEIS/EIS, and the three clauses that bite founders at the next round.
When a founder and an investor cannot agree a valuation, or want to move faster than a priced round allows, they reach for a convertible: money now, shares later, price set by the next round. It is a useful instrument and a frequently misunderstood one. The discount and the cap compound in ways founders do not see until the next round closes and they find out what they gave away.
How a convertible loan note works
The investor lends the money. At the next priced round, the loan converts into shares at that round's price, less a discount — typically 15–25% — to reward the early risk. Often there is also a valuation cap: the maximum valuation at which the note converts, whatever the round price. Interest may accrue (often 8–10%) and converts with the principal. If no round happens by a long-stop date, the note either converts at a fixed valuation or becomes repayable.
The arithmetic
£200k note, 20% discount, £3m cap. Next round is priced at £5m pre-money. The note converts at the lower of: the round price less 20% (£4m), or the cap (£3m). So it converts at £3m — the investor gets £200k ÷ £3m of the pre-round company, about 6.7%, for money that a round investor would have paid £5m for. If the next round had been at £2.5m, the note converts at £2m (discount beats cap). Either way the note holder does better than the round investor, which is the point; what founders miss is that the cap is effectively a valuation you have agreed now, for the note, without calling it one.
Advance subscription agreements
An ASA is the SEIS/EIS-friendly cousin. The investor pays now for shares to be issued at the next round (or by a long-stop date, commonly six months), at a discount. Unlike a loan note it is not debt — it cannot be repaid and carries no interest — which is what keeps it within the schemes. HMRC expects a long-stop of no more than six months and no investor protections that make it look like a loan. Use an ASA when your investors want SEIS/EIS and you are genuinely close to a priced round.
What each does to SEIS/EIS
A convertible loan note is debt and does not qualify at issue; the shares it converts into may or may not qualify depending on the facts at conversion, and relief is often lost. An ASA, done properly, qualifies — the shares are treated as issued when the ASA is paid. If your investors care about relief, and most UK angels do, use an ASA or a priced round, not a loan note.
Three clauses that bite at the next round
- Most-favoured-nation. The note gets any better terms offered to later investors. Harmless until it isn't.
- Conversion triggered by a small round. If "qualifying round" is defined as any raise over £50k, a tiny top-up can trigger conversion at a low cap. Set the threshold to a real round.
- Repayment on demand at the long-stop. If the round slips and the note becomes repayable, you have a creditor, not an investor. Negotiate conversion at a fixed valuation instead.
When to use which
Priced round when you can agree a valuation and have three months. ASA when investors want SEIS/EIS and the round is near. Convertible loan note when it is a bridge from an existing investor who understands the instrument and relief does not matter. Never as the first money in from angels who expect SEIS.
Questions founders ask
"Is a convertible cheaper than a priced round?"
In legal fees, slightly. In dilution, usually not — the discount and cap are a price, paid later. Founders who think they avoided the valuation conversation have usually just lost it.
"What discount is normal?"
15–25%. Above 30% is expensive money; below 10% the investor is not being paid for the risk and will ask for a cap instead.
"Can a note holder block the next round?"
Only if the note says so. Read the consent clauses as carefully as the conversion clauses.