Should founders use a convertible loan note or an advance subscription agreement?

When a startup needs funding quickly but is not yet ready to agree a valuation, founders will often consider either a convertible loan note (CLN) or an advance subscription agreement (ASA). Both enable investment to be made before a priced funding round, with the investor receiving shares at a later date. However, while the commercial outcome can be similar, the legal structure and practical implications are quite different.

CLN

A CLN is a debt instrument. The investor lends money to the company, with the expectation that the loan will convert into shares when a future funding round takes place. Until conversion, the investor is technically a creditor of the company, and the loan may carry interest and include repayment rights if conversion does not occur.

ASA

By contrast, an ASA is not debt. The investor pays money upfront in return for a contractual right to receive shares in the future. There is generally no loan, no accruing interest and no obligation on the company to repay the investment. The funds become available to the company immediately, while the issue of shares is deferred until an agreed trigger event.

Key commercial terms

Despite these structural differences, many of the key commercial terms are similar. Both CLNs and ASAs usually provide for conversion on a future funding round and often include a valuation cap and a discount on the price paid by new investors. These mechanisms reward investors for taking early-stage risk while postponing valuation discussions until a later stage of the company’s growth. Documentation will also typically address what happens if no qualifying funding round occurs within a specified period.

The longstop mechanics are particularly important. Under a CLN, the parties may negotiate what happens if the next funding round does not occur, including repayment, maturity or alternative conversion rights. Under an ASA, particularly where SEIS or EIS treatment is relevant, the instrument should be structured as an advance subscription for shares, not as a repayable loan, so the longstop date and share issue mechanics need careful attention at the outset.

Advantages and disadvantages

The main attraction of a CLN for investors is that it can offer a more protective structure than an ASA. Depending on its terms, a CLN may include interest, a maturity date, repayment rights, default provisions and negotiated conversion protections. However, those protections come at a cost: the company is taking on debt, and the additional rights can create more negotiation, more consent issues and more complexity for the next equity round.

An ASA is often viewed as the more founder-friendly option. As there is no debt element, the company avoids the burden of future repayment obligations and can focus on growth rather than managing creditor relationships. ASAs are generally simpler to document. Where investors are seeking Seed Enterprise Investment Scheme (SEIS) or Enterprise Investment Scheme (EIS) relief, an ASA can be the more natural starting point, but only if it is carefully structured: it should not be repayable or interest-bearing, should include an appropriate longstop date and should be checked against the relevant tax requirements before completion. However, some investors may be less comfortable with the reduced level of protection compared to a loan-based structure.

When each structure is appropriate

In practice, the right choice depends on the circumstances of the fundraising. Where founders want a quick and efficient bridge to a future equity round, an ASA will often be the preferred route. Where investors require stronger downside protection or greater flexibility if a future funding round does not materialise, a CLN may be more appropriate.

As a practical rule of thumb, founders should consider an ASA first where SEIS/EIS relief, speed and avoiding debt are important. A CLN may be more appropriate where investors require interest, repayment rights or stronger downside protection. If the timing of the next round is uncertain, the fallback mechanics should be considered carefully before either structure is chosen.

Neither structure is inherently better than the other. The key is to ensure that the funding instrument aligns with the company’s growth plans, the expectations of the investors and any tax-driven considerations from the outset.

If you are considering bridge funding, an ASA or a CLN, Birketts’ Early Stage Funding & Venture Capital team can help you test the right structure against your next funding round, investor expectations, SEIS/EIS considerations and dilution modelling.