Convertible Loan Notes

Loan notes

There can be advantages to borrowing from investors who already have a stake in your company rather than bringing in new shareholders or issuing further equity. However, there are also risks.

What are loan notes?

Loan notes are a formal type of debt instrument between the lender and borrower setting out the amount of the loan, when the loan is repayable, how much interest is payable and what happens if the loan is not repaid on time.

What's the difference between a loan note and other types of loan agreements? The differences tends to lie in the circumstances in which loan notes are used (see below). Loan notes often include the option to convert some or all of the loan into equity and are often used in more flexible and unusual ways than a standard type of loan agreement. Loan notes are often used on the sale of a business, as part of private equity investment and where multiple lenders are involved.

What are Convertible loan notes?

Convertible loan notes (CLN) are a type of loan note that gives the lender the right, in specified circumstances, to convert some or all of the debt into shares rather than receiving repayment in cash. The loan notes are described as convertible because, if the relevant conversion conditions are satisfied, the debt is converted into shares and the corresponding amount of the loan is treated as discharged.

Convertible loans will often include provisions dealing with future investment rounds, giving the holder the opportunity to convert the investment into shares at a discount or by reference to a valuation cap. For example, conversion may occur on a down round (i.e., where new investment is achieved at a price that is less than the price paid by an  existing investor).

Uses of loan notes

Loan notes are quite widely used. Investors often use loan notes for the bulk of an investment alongside smaller equity investment.

There are certain situations where loans notes are more likely to be used than a loan agreement, including : -

• As consideration under a share sale – known as vendor loan notes and typically issued by the buyer of a company to the seller for part of the purchase price that the seller has agreed to defer and be paid at a later date.
• For investment in a company – this would allow the company to get funding into the business without having to give away a large share of the company at an early stage. Investors also like to use loan notes as a way of investing into a company in the first instance, but typically have an option to convert the loan notes into shares should the company decide to raise funds in the future by way of equity, or may structure their investment as part equity and part debt. Loan note holders rank as creditors rather than shareholders, although their priority will depend on the terms of the loan notes and any security.
• Multiple lenders – where multiple lenders are involved, loan notes provide an effective way to document and evidence debt to the various lenders, and there are often also mechanisms as to how the loan notes can be transferred from one lender to another.

What are the benefits?

For companies scaling-up, loan notes can enable companies to raise funds quickly and cost efficiently. With fewer documents to draft and negotiate compared with an investment round, the company is able to receive cash, without incurring the same level of legal costs associated with a larger equity investment and without being required to give away equity when the company has a low value.

An advantage of loans rather than equity is that lenders generally rank ahead of shareholders in an insolvency.

For investors, convertible and non-convertible loan notes can reduce the risk of investing in a young company. CLN's offer the possibility of repayment if the company does not complete a qualifying investment round. Alternatively, if the company scales-up and the loan converts, the investors could receive shares at a discounted rate. If the company folds, the investor as a creditor may rank ahead of shareholders when the company's assets are distributed, although this does not guarantee repayment.

What are the risks or drawbacks of loan notes?

A separate class of shares may need to be considered where conversion is part of the agreement and voting, dividends and distribution rights will need to be negotiated. The rights attaching to the conversion shares should be considered carefully to avoid the investor becoming equivalent to a founder shareholder in terms of share rights, coupled with a high interest rate and large discount. This could result in the investor acquiring a significant interest in the company and therefore greater control than originally intended.

There will often be default conversion provisions triggered by, for example, a long stop date, and a (usually long) list of breaches, change of control etc.

CLN's will often include redemption provisions, where a list of triggers will allow the investor to redeem the loan instead of converting to shares. This means finding the money to repay the investor or, if they are willing to wait, the investor becoming a creditor with a high interest rate, both of which are likely to cause financial/investment problems for a business.

In some cases, the directors may have been required to provide personal guarantees as to repayment of the loan – default can give rise to personal liability and potentially serious financial consequences. Often the loan note holder reserves the right to appoint administrators.

What documents and process is needed with loan notes?

The starting point is to review the company’s articles of association and consider if a new class of share needs to be created for any conversion shares.

On the basis that there are no changes required to the articles or classes of shares, the next step is to draft and negotiate the loan note instrument.

Following this, entry into the CLN will need to be agreed by the board and, if applicable, the company will need the necessary shareholder authority to allot the shares and, where relevant, to disapply statutory or contractual pre-emption rights. The precise approvals will depend on the company's articles, existing shareholder arrangements and the terms of the proposed conversion.

If the loan note is redeemed, the loan note should be returned to the issuer for cancellation and this should be recorded in board minutes and any register of debentures.

Recent Experience

Below are some case studies for situations in which we have advised clients on loan notes :-

• Loan agreement examples
• Loan notes problems case study

Please do get in touch if you are considering entering into a loan note – we can point you in the right direction. If we are drafting the loan note or convertible loan note fees will be greater and we will scope and quote.