Convertible securities

Convertible securities

Author: The Carta Team
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Read time:  7 minutes
Published date:  9 August 2024
In this article, we’ll cover everything you need to know about three common convertible securities (convertible loan notes, advance subscription agreements and SAFEs) and how they’re used in unpriced funding rounds.

When you’re raising money for your startup, don’t assume you’ll need to offer up preferred shares right away in exchange for capital. That’s one option, but there are other investment structures available for early-stage companies, such as convertible securities. In this article, we’ll cover everything you need to know about three common types of convertible securities: 

  • Convertible loan notes (CLNs)

  • Advance Subscription Agreements (ASAs)

  • Simple Agreements for Future Equity (SAFEs)

What are convertible securities? 

Convertible securities – also known as convertible instruments or convertibles – are financial instruments that allow invested funds to be converted into equity in a company  at a future date. 

The key advantage of convertibles is that founders can use them to raise capital without a set company valuation. This matters for very early-stage startups that haven’t yet raised a priced round from investors or been valued by the market. At this stage, many founders and investors turn to convertibles because they’re typically faster, cheaper and more flexible than raising money via a priced round.

How do convertible securities work?

Convertibles come into the picture during fundraising – or, more specifically, during an unpriced funding round. In exchange for cash investment, a company may issue a convertible security that either represents an amount to be paid back to the investor, or converts into equity at a later date – usually during the next “priced” round. In some instances – such as a liquidity event happening before the conversion can take place – the investor could receive a cash payout instead of equity.

Convertible securities calculator

If you’re seeking early-stage investment, it’s important to understand the potential impact of different fundraising scenarios and dilution terms on your cap table. This will put you in a stronger position to negotiate with investors and secure the best possible deal for your business.

The most common convertibles used by startups in the UK and Europe are ASAs, CLNs and SAFEs. With Carta’s free convertible securities calculator, you can model an unpriced round to see how the conversion of these instruments into equity could affect your company ownership structure.

Here’s how to use the tool:

  1. Enter the expected terms of future priced round

  2. Add details of any unpriced instruments (e.g. CLNs, ASAs or SAFEs)  – including the value, discount (if applicable) and dilution terms

  3. View the impact of conversions on your cap table and specific stakeholders (including founders and investors) at the point of a priced round

Understand the potential future impact of CLNs, ASAs and SAFEs before you fundraise.
Use the calculator

What is a convertible loan note (CLN)?

A convertible loan note – sometimes called a convertible note – is debt that is either paid back (in cash) or converted into equity upon a qualifying event or transaction, such as a priced equity round raised from venture capital investors

How does a convertible loan note work? 

As debt instruments, convertible loan notes have an interest rate and a maturity date (when the note expires). If the CLN hasn’t already converted into equity by the maturity date, the company is typically required to repay the initial investment amount plus interest.

Imagine that an investor provides £100,000 of funding at an 8% interest rate in exchange for a CLN that matures in one year. If the company hasn’t raised a priced funding round within 12 months, it would need to pay the investor back £108,000 rather than converting the debt into equity.

However, if both parties want to extend the maturity date, they can amend the terms of the CLN. Until the note either converts into equity or is repaid by the company, it will continue to accrue interest.

Convertible notes often include a valuation cap, a conversion discount or both. These features allow early investors to subscribe to company shares at a lower price than that paid by later investors, incentivising them to take a chance on a high-risk business.

  • Valuation cap: The maximum company valuation (for the purpose of determining the price per share) at which an investment will convert into equity during the next priced round. This rewards early investors by capping the conversion price if a company’s valuation rises quickly.

  • Conversion discount: A reduction on the price per share when a CLN converts into equity. As an example, CLN investors could convert their investment into shares at a 20% discount compared to other investors buying shares in the same round.

If a convertible loan note has both a valuation cap and a discount rate, the investor can typically take advantage of whichever option results in the lowest conversion price per share (depending on CLN terms). 

What is an Advance Subscription Agreement (ASA)?

An ASA is a financing instrument that converts into equity in the future. ASAs are popular in the UK because of their compatibility with the Seed Enterprise Investment Scheme (SEIS) and Enterprise Investment Scheme (EIS), which offer tax relief to investors who fund qualifying companies.

How do ASAs work?

Like convertible loan notes, ASAs often include a valuation cap and/or conversion discount. However, ASAs don’t accrue interest because they’re not a debt instrument.

The terms of the ASA typically provide for multiple conversation scenarios. Generally, the investment converts into shares when a ‘qualifying funding round’ takes place, at a predetermined longstop date or upon an exit event (such as a merger, acquisition or IPO).  

Qualifying funding round

For a funding round to ‘qualify’ and trigger the conversion of ASAs into shares (usually at a discount), the company needs to meet a specific fundraising target. Setting this target requires a careful balance between the needs of founders and investors:

  • For investors, a higher target ensures the company is well-capitalised when the ASAs convert, maximising their potential return

  • From a founder’s perspective, setting the target too high may prevent the investment from converting to shares despite the business receiving substantial investment

Longstop date

The longstop date ensures the ASAs will convert in a specified time frame, even if there isn’t a qualifying funding round or company exit. For startups using ASAs to raise money through venture capital schemes like SEIS and EIS, HMRC rules mandate that an ASA must convert into shares no more than six months after issuance. So, if the company doesn’t raise qualified financing within six months, the ASAs will convert into equity (often at a discount to the current share valuation).

As part of the ASA conversion process, startups need to complete certain documents – including a shareholders’ agreement, subscription agreement and articles of association (if these are not already in place). While the British Private Equity & Venture Capital Association (BVCA) offers free templates, working with a lawyer will ensure these documents are executed properly.

What is a Simple Agreement for Future Equity (SAFE)?

SAFE stands for Simple Agreement for Future Equity. In recent years, SAFEs have become  a common convertible instrument for startups due to their relative simplicity. Like CLNs and ASAs, SAFEs typically convert into shares during a future priced round. Unlike convertible notes, they don’t have a maturity date or interest rate. 

How do SAFEs work? 

Investors who hold SAFEs have the right to convert their investment into company shares when a pre-agreed trigger event occurs, such as a priced round. The terms of conversion are typically defined by either a valuation cap or a discount rate. This discount effectively lowers the priced round valuation used to calculate an investor’s share price, allowing them to convert their SAFEs into more equity. For SAFEs issued with both a valuation cap and a discount rate, investors have the right to choose the better option upon conversion. 

Convertible notes often require the company to raise a certain amount of capital for automatic conversion into equity, whereads SAFEs tend to convert regardless of the round size.

SAFEs can be “pre-money” or “post-money”. While a pre-money SAFE investor may be diluted by further investments before a priced round occurs, post-money SAFEs provide more certainty around ownership going into the priced round.

Comparing convertible securities

Here’s how CLNs, ASAs and SAFEs compare:


CLNs

ASAs

SAFEs

Type of instrument

Debt

Equity

Equity

Valuation cap

Conversion discount

Maturity date

Accrues interest

Pros and cons of convertibles

Convertible securities can be a good option for early-stage startups that need quick access to capital but also want to reach certain milestones before raising a priced round. Although the security they offer is a huge advantage, there are several downsides to using convertibles, including founder share dilution.

Pros

Cons

Fast and affordable: fewer terms to discuss with investors means you spend less time negotiating and less money on legal fees.


Can cause unexpected dilution: if you raise too much money through convertibles, or if they convert at low valuations relative to a future priced round, this can dilute your ownership stake more than you might expect.

No fixed valuation: it’s difficult to predict how your business will grow, so raising an unpriced round gives you more time to accurately measure your company’s value before the next (priced) round.

May still require an effective valuation: if you decide to put a valuation cap on a CLN, ASA or SAFE, you’ll eventually need to agree on a pre-money valuation proxy.

Retain majority control: you don’t have to give up control of your business straight away. Investors leading priced rounds typically expect a board seat and preferred share voting rights.

Can limit other investment opportunities: without a clear lead investor to stir up interest in your company, it might be difficult to secure other investments.

Rolling round closings: you can raise capital from several different investors over an extended period of time, rather than all at once. You also don’t need a lead investor for unpriced rounds.

From modelling an unpriced round to generating ASA and SAFE documents, find out how Carta can speed up your fundraise.
Learn more

The Carta Team
While we believe in assigning ownership at Carta, this blog post belongs to all of us.

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