Valuing Convertible Loan Notes Before an Equity Round

A convertible loan note can look harmless when it is signed. It is debt today, but it may become a meaningful shareholding when your next equity round closes.

For UK SMEs and start-ups, that can affect founder ownership, investor returns and the valuation discussion before a term sheet is agreed. The original loan amount is only part of the picture. The note terms determine how much dilution may follow.

Consult EFC helps founders put clear numbers around those terms before negotiations become expensive or difficult to unwind.

What a Convertible Loan Note Means for Your Next Funding Round

A convertible loan note is a loan made to a company that can convert into shares at a later date. The investor provides cash now. Rather than setting a share price immediately, the parties agree how the loan will convert when a future event occurs.

That future event is often a priced equity funding round. It may also be a sale of the business or the maturity date of the note.

The document should set out the terms that drive its eventual value:

• The principal amount advanced to the company.
• The interest rate and whether interest compounds.
• The maturity date, when the loan becomes repayable or conversion is considered.
• A valuation cap, which sets a maximum valuation for calculating conversion.
• A discount rate applied to the next round’s share price.
• The conversion trigger, often called a qualified financing.
• Investor rights, including information rights, consent rights or sale provisions.

The note’s face value is normally the principal plus any accrued interest. Its value as debt depends on repayment prospects and the terms of the agreement. Its value on conversion depends on the number and class of shares the holder receives.

Those are three different questions. Treating them as one figure is where founder dilution often gets missed.

The note terms that change founder dilution

A valuation cap gives the noteholder protection if the company grows quickly before the next round. If the next investors pay a price based on a valuation above the cap, the noteholder converts at the lower capped price.

A discount offers a different benefit. If the new round price is £2.50 per share and the discount is 20%, the noteholder may convert at £2.00 per share.

Most notes state that the holder receives the more favourable result, either the discounted price or the cap price. The exact drafting matters. A cap and discount are not always applied in the same way.

Interest can add further dilution. Many agreements allow accrued interest to convert alongside the principal. A £200,000 note with £10,000 of interest may therefore convert £210,000, not £200,000.

A low conversion price is good for the noteholder. It is not automatically good for the founders or incoming equity investors.

When does the note convert into shares?

A qualified equity round is the usual conversion trigger. The note may require the company to raise a minimum amount, such as £500,000 or £1 million, before automatic conversion applies.

If the planned round is smaller, the noteholder may need to consent to conversion. The agreement might allow optional conversion, repayment or a revised arrangement. Informal discussions are not enough.

A sale before conversion can produce a different outcome again. The holder may receive repayment, a return multiple, or the amount they would have received on conversion. The sale provisions need close review.

At maturity, the debt does not disappear. The company may need to repay it, agree an extension, or convert it under the stated terms. If the fundraising round occurs after maturity, the signed note determines the position. Check the document and any formal amendments, not what participants recall agreeing over email.

How to Value Convertible Loan Notes Before an Equity Round

A proper review starts with the company’s current position and works through the note mechanics. It is not a simple calculation based on the cash advanced two years ago.

The likely equity valuation matters because it sets the next round share price. The contractual cap and discount then determine whether the noteholder receives a lower conversion price. The resulting share issue changes the ownership of everyone already on the cap table.

Start with the company’s current value and funding position

The valuation work needs reliable source material. Recent statutory accounts, management accounts, forecasts, cash-flow plans and the planned fundraising amount are central.

You also need the current share capital, option pool, existing share classes, previous funding terms and all note balances. A cap table based only on issued ordinary shares is rarely enough.

Business performance affects the valuation used for the round. Revenue quality, customer concentration, gross margin, recurring income, cash burn and the time needed to reach the next funding point all matter. So do market conditions and the availability of investor capital.

A company with signed contracts and controlled cash burn will normally support a different valuation case from a company with forecast revenue but limited funding runway. The assumptions need evidence. Aspirational figures do not hold up well in investor due diligence.

Compare the main valuation methods

There is no single method that suits every SME or start-up. The right approach depends on the business, its trading history and the purpose of the valuation.

A discounted cash flow model can be useful where forecasts are detailed and capable of support. It assesses expected future cash generation, then discounts it for time and risk.

EBITDA multiples are often relevant for established profitable businesses. Revenue multiples may be more suitable for growth businesses where profitability is not yet the main value driver. Comparable transactions can provide a market sense check, although truly comparable private transactions are often limited.

For earlier-stage businesses, recent arm’s-length funding, progress against commercial milestones and market benchmarks may carry more weight. Different methods can produce a valuation range. That is normal. The key is that the selected assumptions are clear, factual and defensible.

Calculate the likely conversion price and shareholding

Consider a company with 1,000,000 ordinary shares, all held by the founders. It has a £200,000 convertible note, £10,000 accrued interest, a £2 million pre-money valuation cap and a 20% discount.

The company plans a £500,000 equity round at a £2.5 million pre-money valuation. The new round price is £2.50 per share.

The noteholder receives 105,000 shares because £210,000 converts at £2.00 per share. The founders’ holding falls from 100% to 76.63% after both the note conversion and new investment.

A pre-money valuation cap and a post-money valuation cap are not interchangeable. The latter may define ownership after accounting for converting instruments in a different way. Small drafting differences can materially change the ownership result. Model the precise wording before agreeing the round.

What Founders and Investors Should Check Before Agreeing the Round

A valuation review gives both sides a factual basis for negotiation. It does not guarantee the price a new investor will pay. It does show the consequences of different prices before documents are signed.

The focus should be practical: who owns what after conversion, what rights attach to those shares and whether the proposed round remains investable.

Review the cap table and all existing investor rights

Review ordinary shares, preference shares, options, EMI awards, warrants, other convertible notes and any equity already promised to advisers or employees. A fully diluted cap table normally provides the clearest picture.

This includes shares that may be issued under an option scheme, even if the options have not yet been exercised. It also includes instruments that convert on the same financing event.

Conversion may affect voting control, board rights and liquidation preferences. New investors will look at these points closely. A clean cap table and a documented conversion analysis reduce the risk of late-stage objections.

Test the numbers under different funding outcomes

One model is not enough. Test the likely round, a lower valuation, a delayed raise, a down round and a sale before conversion.

A strong round may mean the valuation cap drives conversion. A lower valuation may mean the discount produces the better result. A delay can increase accrued interest and bring maturity terms into play.

The founders should understand whether the cap is too low relative to the company’s current progress. Investors should assess whether it is too high for the risk they accepted when funding the business. The aim is not to make every outcome identical. It is to avoid surprises.

Separate valuation advice from legal and tax advice

A valuation report does not replace advice on the loan note agreement, Companies Act requirements, tax treatment or shareholder documents. Each has its own purpose.

Changes to share capital can also affect an EMI scheme and any share valuation work involving HMRC Shares and Assets Valuation. The final terms should be reviewed by the appropriate UK solicitor and tax adviser before completion.

A Practical Valuation Process Before Fundraising

Consult EFC uses a partner-led process for SMEs and start-ups that need an independent valuation before an equity round. The work begins with the note documents and company records, then moves into financial analysis, valuation modelling and conversion scenarios.

The conclusions should be clear enough for founders, investors, accountants and solicitors to use. A written report can support funding discussions and due diligence review. Agree the fixed fee, scope and turnaround at the start.

Information to prepare for the valuation

Good records reduce delay and improve the quality of the conclusion. Prepare the following before the work begins:

• Signed convertible loan notes, amendments and interest schedules.
• The latest cap table and shareholder agreements.
• Management accounts, statutory accounts and cash-flow forecasts.
• Funding plans and any proposed equity term sheet.
• Details of relevant comparable businesses or recent transactions.
• Information on options, EMI awards, warrants and previous funding rounds.

If a document is missing, say so early. It is better to identify a limitation than build a valuation around an assumption that later proves wrong.

Questions to ask before relying on a valuation

Ask for the valuation date and the methods used. Ask which assumptions have the greatest effect on the result, particularly revenue growth, margins, cash requirements and the treatment of debt and cash.

You should also ask how the conversion mechanics were applied, whether the cap is pre-money or post-money, and how dilution was calculated. The intended use of the report matters too. A report prepared for internal planning may need more support before it is used in a formal investor process.

A technically correct answer is not enough if nobody can follow it. The report should explain the assumptions and ownership outcomes in plain English.

Conclusion

Valuing a convertible loan note requires three things: a credible view of the company’s current worth, a close reading of the signed terms and a clear model of conversion.

Dilution should be calculated before the negotiation, not discovered after completion. Founders need to see the ownership cost of the note. Investors need to test whether the terms still match the risk they took.

Consult EFC can provide an independent UK business valuation and conversion review before the equity round is agreed.

Kishen Patel, BFP ACA Founder, Consult EFC · ICAEW Chartered Accountant

Over 12 years across Big Four audit, Investment Banking and corporate advisory. Kishen works with UK SMEs on valuations, exit planning, fundraising and financial strategy. ICAEW regulated. Big Four trained. Based in London.