A convertible loan note is a loan to a company that may turn into shares later; an advance subscription agreement is money paid now for shares the company will issue later. Both usually give the investor a better price than the next round, but only an ASA can qualify for SEIS or EIS relief, and only on HMRC’s strict terms. Shares that come from converting a loan generally do not qualify.
How a convertible loan note works
A convertible loan note (CLN) starts life as debt. The investor lends money, the company records a liability, and the note sets out when and how the debt turns into shares. The main terms are:
- Interest, which is often rolled up and converted into shares rather than paid in cash.
- A maturity date, by which the note must be repaid or converted if nothing else has happened.
- Conversion events, typically the next equity round above a minimum size, a sale of the company, or maturity.
- A discount to the price new investors pay in the next round.
- A valuation cap, the highest valuation at which the note converts.
None of these is fixed by law. They are commercial terms, and two notes from the same company can differ, so each needs reading in full.
Discounts and caps in practice
A hypothetical example shows how the two interact, ignoring interest. An investor holds a £50,000 note with a 20% discount and a £4m valuation cap. The next round values the company at £8m before the new money, at £1.00 a share. The discount gives a conversion price of £0.80. The cap gives the price implied by a £4m valuation on the same share count, £0.50. The note converts at the lower price, so the investor receives 100,000 shares rather than 62,500. The cap rewards the note holder when the valuation rises quickly, and the founders and new investors bear the cost.
A note also has to say what happens if the company is sold before any round, or reaches maturity without one. At maturity, a right to repayment is only as good as the company’s cash. Until conversion the investor is a creditor: in a voluntary winding up, a company’s property is applied to its liabilities before anything is distributed to its members (Insolvency Act 1986, s107). In a failed start-up there may be little left for anyone.
How an advance subscription agreement works
An ASA is not a loan. The investor pays the subscription money now, and the company agrees to issue shares later, typically at the next funding round and at a discount, sometimes with a cap. If no round happens by the longstop date, the shares are issued on fallback terms set out in the agreement. There is no interest and, for SEIS or EIS purposes, no right to get the money back.
HMRC describes ASAs as a way to raise funds quickly “at a time when the value of shares cannot be easily ascertained”, and expects their terms not to be complex. It warns that the more complex the agreement, or the longer the gap before the shares are issued, the higher the risk that the SEIS rules will not be met (VCM33025).
When an ASA qualifies for SEIS or EIS
HMRC’s guidance is in the same terms for SEIS (VCM33025) and EIS (VCM12025). It will not consider an ASA suitable unless the agreement:
- does not permit the subscription payment to be refunded under any circumstances;
- cannot be varied, cancelled or assigned;
- bears no interest; and
- has a longstop date by which the shares must be issued.
As a general rule HMRC expects the longstop date to be no more than six months after the ASA is signed, and says it is unlikely to give advance assurance where the period is longer. The ASA must not work as an investment instrument offering other benefits such as investor protection, the payment must not in effect be a loan, and an ASA used wholly or partly to convert a debt or other obligation into shares will not be considered eligible.
Timing matters too. SEIS relief is available only from the date the shares are issued, and the company should not submit its compliance statement before then. A company wanting advance assurance should apply before entering the ASA; HMRC will not give further assurance on later changes, which it considers only when the compliance statement arrives. The company tests still apply at issue: for SEIS, gross assets must not exceed £350,000 immediately before the shares are issued (Income Tax Act 2007, s257DI), though HMRC does not count an advance payment received for that share issue, such as money paid under an ASA, among the company’s assets immediately before the issue (VCM34100).
Why convertible loan notes generally do not qualify
The law requires EIS shares to be “subscribed for wholly in cash” and fully paid up when issued, and says shares are not fully paid up if there is an undertaking to pay cash for them at a future date (Income Tax Act 2007, s173). HMRC applies the same requirement to SEIS shares (VCM33020). When a note converts, the shares are issued in exchange for the debt rather than for new money, and HMRC’s ASA guidance makes the point directly: an arrangement used to convert a debt into shares will not be considered eligible (VCM33025).
There is a knock-on effect for EIS. HMRC says you cannot claim EIS income tax relief on new shares if you already hold other shares in the company that were neither issued to you when the company was formed nor covered by a compliance certificate (HMRC). Shares from a converted note could fall into that category and affect the holder’s relief in later rounds. For investors who want SEIS or EIS relief, the practical choice is between an ASA that meets HMRC’s conditions and a straight subscription for shares.
The three instruments compared
| Convertible loan note | Advance subscription agreement | Equity subscription | |
|---|---|---|---|
| What the investor holds before shares are issued | A debt owed by the company | A paid-up agreement to receive shares later | Shares from day one |
| Interest | Can carry interest, often rolled up into the conversion | None; HMRC will not accept an ASA that bears interest | None; any dividends are paid at the company’s discretion |
| Can the money come back? | Yes, at maturity or on agreed events, if the company can pay | No; HMRC requires that the payment cannot be refunded in any circumstances | No |
| Share price | Set later, usually with a discount, a cap or both | Set later, usually with a discount, a cap or both, with fallback terms at the longstop date | Agreed now |
| If the company is wound up before shares are issued | A creditor, paid before shareholders if anything is left | Depends on the agreement | A shareholder, paid only after creditors |
| SEIS or EIS relief | Generally not available | Available if HMRC’s conditions are met, from the date the shares are issued | Available if the company, the shares and the investor qualify |
| Time until shares | Until a conversion event or maturity | Up to the longstop date, which HMRC generally expects within six months | Immediate |
Sources for the table: VCM33025, VCM12025, ITA 2007 s173 and Insolvency Act 1986 s107.
Regulation and protection
When unlisted shares or debt securities are promoted to the public through a platform, the FCA generally treats them as non-readily realisable securities, a class of restricted mass market investment that comes with prescribed risk warnings, a 24-hour cooling-off period for new customers and an appropriateness test (FCA Handbook, COBS 4.12A). The FCA’s risk summary for these debt securities warns that “Most start-up and early-stage businesses fail” and that advertised rates of return are not guaranteed (COBS 4 Annex 1). FSCS protection does not cover poor investment performance.
What to check before you sign
- The instrument. Is it a loan note, an ASA or a share subscription, and does the company expect the shares to qualify for SEIS or EIS?
- The price mechanics. The discount, any cap, and how the price is set at the longstop date, at maturity or on a sale.
- For a CLN: the interest rate, the maturity date, whether the note is secured, and what happens if the company cannot repay.
- For an ASA: no refund, no interest, no variation, cancellation or assignment, and a longstop date within HMRC’s six-month expectation if relief matters to you.
- Advance assurance. Whether the company sought assurance before the ASA was signed, which is when HMRC’s guidance says it should apply.
- The shares you will receive. For SEIS or EIS they must be ordinary shares with no preferential right to assets on a winding up and no right to be redeemed (HMRC).
Founders weighing the options can start with our guide to raising under SEIS. Our sister title SEIS Investments has founder-side guides to advance subscription agreements and structuring a round. On TID, see what advance assurance tells an investor, investing in early-stage companies and SEIS for investors.
