Key takeaway

For many businesses, particularly those operating in regulated or credibility-sensitive sectors, how funding appears on the balance sheet can materially affect stakeholder confidence, regulatory perception and future fundraising strategy. In this article we discuss the accounting issues around a popular capital-raising structure – convertible loan notes (CLNs).

What are convertible loan notes?

Convertible loan notes (CLNs) are a type of startup financing instrument that starts as a loan but can later convert into equity (typically preferred shares) in the company, usually during a future investment round.

Why are convertible loan notes used?

Convertible loan notes (CLNs) are frequently used to raise significant capital, sometimes in excess of £100m. Although legally structured as debt, they are often intended, commercially and strategically, to achieve equity classification in the accounts. They are therefore listed as a net positive rather than debt.

What are the advantages of convertible loan notes?

CLNs are attractive to businesses because they offer a quick and flexible solution for capital needs. CLNs achieve their purpose as a tool for debt deferral by offering a few specific benefits:

●      No contractual right for investors to demand redemption at maturity;

●      Conversion into a fixed number of shares at a fixed price (for example, at a discount to the next funding round);

●      The interest accrued can also be converted into shares at the discounted rate; and

●      Investor risk protection delivered through liquidation preference principle rather than repayment rights.

In commercial terms, these instruments are intended to behave like equity. Theinvestors expect to participate in upside through share conversion, and not tobe repaid as creditors in the ordinary course.

What are the accounting issues of CLNs?

Theissue with CLNs arises under IAS 32, in accordance with International Financial Reporting Standards, focusing not on commercial intention but on whether the instrument contains a contractual obligation to deliver cash or another financial asset. The test is technical and binary: does the instrument contain a contractual obligation for the issuer to deliver cash (or another financial asset)?

If the answer is yes, the instrument is generally classified as a financial liability (i.e. debt).

If a CLN states that, on a sale of the company, investors are entitled to receive cash rather than shares, that clause may create a contractual obligation to deliver cash. It does not matter that:

●      The payment would only arise if the company is sold;

●      The company expects the buyer tofund the payment out of transaction proceeds; or

●      The economics are designed tomirror what shareholders would receive on exit.

From an IAS 32 perspective, the perception does not remove the obligation. The key question is whether the company has an unconditional right to avoid paying cash. If it does not, the liability classification risk arises. In short, even a remote or exit-driven cash settlement mechanism can shift a CLN from equity to debt, because of the existence of a contractual cash obligation.

What is the impact of IAS 32 on CLNs?

If a CLN is classified as debt, a liability may appear on the balance sheet. This could affect solvency calculations, liquid reserves, and compliance with financial regulations, potentially restricting how the company can operate or distribute profits.

CLNs may cause later-stage investors to reassess the company’s leverage and risk profile, which can influence terms, pricing, and willingness to invest. Similarly, customers, regulators, or commercial partners may view the business differently if significant debt is visible, even if the economics of the investment have not changed. Read more in our guide to preparing a business for sale in 2026.

Conclusion

CLNs are a flexible way to raise capital, but the accounting classification is determined by contractual obligations, not commercial intent. Small drafting choices, especially around cash settlement, can have disproportionate consequences. To protect balance sheet presentation, debt–equity considerations should be addressed at the structuring stage.

Please contact the Corporate team at Barnes Law for advice on convertible loan notes.

Authored by Barnes Law Managing Partner, Yulia Barnes.