Alternative funding sources for startups: CLNs, ASAs & SAFE Notes

Summary (TLDR) of funding sources for start-ups

A Convertible Loan Note (CLN) is a short-term debt instrument that is typically converted into equity shares in the business at a later date. The investor will typically receive a discounted share price, usually based on the valuation of a future funding round.

A SAFE Note (Simple Agreement for Future Equity) acts as a promise to allow an investor to purchase a specified number of shares, at a pre-agreed price, at a future point.

Similar to a SAFE Note, an Advance Subscription Agreement (ASA) is an investment for equity where the investor pays in advance (often at a discounted rate) for shares that will be allocated at a later date. Under an ASA, the investor can still benefit from SEIS/EIS tax relief when the shares are issued – providing more of an incentive to invest in the first place.

What is a Convertible Loan Note & how does it work?

Option 1 of funding sources: CLNs are short-term debt instruments through which loans are typically converted into equity shares at a later date. CLNs are commonplace in the US and are becoming increasingly common in the UK with non-S/EIS investors. They are commonly used in circumstances where it may be difficult to place a value on the company. This may be due to the company being in its early stages or as part of a bridge round.

The notes are ‘issued‘ by the borrower and held by the lenders/investors. They are convertible into the company’s shares and are typically used as a short-term bridging loan between funding rounds. So, instead of being repaid the debt issued under the notes, investors receive shares upon conversion.

CLNs present an opportunity for investors looking for added downside protection as debt ranks higher than equity in the event the company is wound up. They can also benefit the company, as a relatively quick means of obtaining timely investment.

What is an Advance Subscription Agreement (ASA) & how does it work?

Option 2 of funding sources: An Advanced Subscription Agreement is an investment for equity where the investor pays in advance for shares that will be allocated at a future date. Usually, the shares will be issued at a discounted price per share in a future funding round. Similar to a CLN, an ASA is a way for a start-up to receive cash swiftly, as it tends to be a short agreement which is quick to negotiate.

There are some clear advantages to start-ups from using an ASA. The company can avoid the immediate need for a more complex negotiation of a full equity round, and potentially benefit from a higher valuation when the ASA shares are issued. Provided the advanced subscription agreement is structured properly, the investor can benefit from SEIS/EIS tax reliefs when the ASA shares are issued.

What is a SAFE Note & how does it work?

Option 3 of funding sources: SAFE notes (Simple Agreement for Future Equity) act as a promise to allow an investor to purchase a specified number of shares for an agreed-upon price, at a future date, as long as certain terms are met. This instrument was developed out of Y Combinator in the US.

An investor will give a start-up money and receive a promise to get equity, usually at a predetermined price, when certain milestones are met. In addition, they allow companies to get venture capital and push the paperwork, cost and time required from an equity round to a later date. This enables the start-up to move faster, grow, and become more established.

Key differences between CLNs, ASA & SAFE notes

Debt InstrumentYesNoNo
RepayableIf not converted, YesNoNo
Discounted Share Price for InvestorNegotiableNegotiableNegotiable
Interest BearingNegotiableNoNo
EIS EligibleNoYes, if drafted correctlyYes, if drafted correctly

Which funding source is best for your business?

A major consideration when choosing between these instruments is tax. Investors will not be considered eligible for SEIS/EIS tax treatment if a CLN is used.

Whilst specific tax advice should always be obtained, by using the Advanced Subscription Agreement or a SAFE (once correctly drafted), it should be possible for investors to be eligible to obtain SEIS/EIS tax relief. Unlike CLNs, they are not debt and therefore do not accrue interest.

Certain (typically non-UK) investors may prefer the CLN format over the ASA because it is more familiar. CLNs have been around the market for longer, originating in Silicon Valley and are therefore more widely used by US investors.

For more on SEIS/EIS, see Enterprise Investment Schemes (EIS) & Seed Enterprise Investment Schemes (SEIS).

Get legal advice on funding rounds & investment 

At Seven Legal, we specialise in providing start-ups, founders and entrepreneurs with stage-specific legal advice. For start-ups seeking investment, CLNs, ASAs and SAFE Notes are just a few of the funding source options available as a way of securing funds.

Our goal as legal advisors is to help you make informed choices about fundraising. That way, you can manage risks and get the best deal for your business, without giving away more equity than you need to. If you have a legal question on fundraising, please get in touch with our lawyers today.

You can also find more information on fundraising and investments on the client journey or specialisms pages of our website.