Before we get into the details and discuss the key points about convertible notes, we have to first understand in brief what exactly the phrase means in financial parlance.
So what is a CLN? By simple language, this is a liability for a temporary period that may get switched to issue capital stock after a certain stage. This is also called a loan note or a Convertible Loan Note.
Who are the parties involved?
In this arrangement, there are mainly two parties involved, one is the start-up company founder seeking funds, and the other is the investor who invests money.
When the investor funds the company, he gets CLN in return as a security for his investment. Since being an advance given for a new business, it gets classified into a liability or a loan and not as equity. However, based on the condition, this CLN gets transformed into issue capital stock as per the rate that would be decided later; it permits the moneylender to procure it at a depreciated allotment value.
Some reasons to procure CLN?
Firstly, the process of these notes is less cumbersome compared to negotiations involved over capital stock investment.
And second, when the company and these promoters wish to raise preliminary money quickly until such period they get more equity funding later, they can bring their idea to reality.
What are the benefits?
A convertible loan note is mutually beneficial for both parties involved. For the company apart from the point already discussed above, it helps them to postpone the dialogue and process to arrive at the company’s valuation. So, the founders get a breather until they receive equity funding actually.
When it comes to the financier who invested in this start-up, his position is well secured. Therefore, irrespective of which side the start-up’s fortune gets tilted, the venture capitalist stays at an advantageous position. To elaborate on this point further, in case the start-up becomes insolvent, the financier gets first preference over other debtors for procuring the company’s assets whereas if the enterprise becomes profitable; CLN can get changed to discount equity allotment.
To sum up, the primary meaning of a CLN is that it eventually gets switched to liquid capital stock either during the process of raising funds otherwise due to the company’s insolvency.
In rare cases, if equity funding could not be procured before the expiry of the Convertible Loan Note, the organization is bound to repay the debt amount plus the profit that was accrued on that to this financier or simply alter those to liquidity allotment with a discounted rate.