UK Law and Practice Contributed by: Dylan Doran Kennett, Michael Jacobs, Stephen Newby and Mark Ife, Herbert Smith Freehills LLP
type of method chosen will depend on the matu - rity of the business and the type of funding that the situation requires, among other things. CLNs and ASAs are convertible instruments that allow investors to invest money into a compa - ny to be converted into equity at a future date, depending on its terms. • A CLN is a debt instrument with an interest rate and maturity date upon which the CLN will either convert to equity or the company will be obliged to repay the loan and any accrued interest. CLNs provide security to investors in an insolvency situation, as convertible debt ranks ahead of shares in insolvency, so they are viewed as a safer investment than equity. CLNs will generally offer a discount for the investors upon con - version of the note, incentivising the investor for advancing the funds at a potentially riskier point in the company’s trajectory. • An ASA is a convertible equity investment similar to a Simple Agreement for Future Equity (SAFE) in the US, which has all the hallmarks of a CLN without the associated debt. This potentially allows investors to take advantage of Seed Enterprise Invest - ment Scheme (SEIS) or Enterprise Invest - ment Scheme (EIS) tax relief in the UK (see 4.1 Subsidy Programmes ), provided the characteristics of the ASA meet the HMRC guidelines and the company is eligible for such relief. ASAs will typically be triggered to apply subscription funds for equity at a future financing round. Unlike with CLNs, if the com - pany becomes insolvent, investors are not considered unsecured creditors or holders of equity. For both instruments, the discount rate may be applied at the time of conversion, to reward early
investors with a more favourable price per share compared to new investors. A valuation cap may also be introduced, to give investors certainty on the maximum valuation at which their instrument will convert. Convertible instruments are often favoured in seed rounds because venture com - panies may have a limited financial history, mak - ing valuations uncertain and therefore delaying discussions around valuation until a third-party investor ascribes a valuation to what would be a more mature company. Preferred equity refers to shares that have preferential rights to the ordinary equity, nor - mally introduced at seed level investments and beyond. Investors will receive shares outright in exchange for their investment. Preferred shares take priority over ordinary shares, meaning pre - ferred shareholders will be paid out before ordi - nary shareholders in the event of liquidation. The general principle upon liquidation is that “the last money in is the first money out” , and preferred shares aim to achieve that economic protection. Each round of financing often introduces a new class of preferred shares that “stack” on top of one another, with the ordinary equity at the bot- tom. 3.4 Documentation Typical key documents representing a financing round in a growth company include the follow - ing. Term Sheet This is a non-binding document, used as a basis for key legal documents, outlining the fundamen - tal investment terms and conditions between the company, the investors and sometimes the founders. The term sheet plays a pivotal role in shaping the deal and serves as a road map for further negotiations.
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