Convertible Loan Notes

Loan notes

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

What are loan notes?

Loan notes are a formal type of loan agreement 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 agreement. 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 that they 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 they often involve multiple lenders.

What are Convertible loan notes?

This is a type of loan note giving the lender the choice of asking for repayment in cash or by taking other forms of consideration to be used as repayment usually a percentage of the borrower’s shares. The loan notes are described as convertible because if the lender opts for non-cash consideration such as shares to pay off all or part of the loan that part is treated as paid off. Convertible loan notes are usually unsecured.

Convertible loans will often be convertible if there is an investment round  giving the convertible loan note holder the opportunity 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) to convert the investment into shares at the down  round valuation.

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. Investors also like to use loan notes as a way of investing into 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 split their investment as part equity and part debt. Even if the lender does not convert their loan notes, they are great for investors as they will be paid off first before any shareholders.
• Multiple lenders – where multiple lenders are involved, loan notes provide an easy 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 less documents to draft and negotiate compared with an investment round, the company is able to receive cash, without huge legal fees 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 will be repaid before shareholders on insolvency.

For investors, convertible and non-convertible loan notes are a safe way to invest in a young company. Convertible loan notes offer security if the company is unable to complete a qualifying investment round, the loan can be repaid. Alternatively, if the company scales-up and the loan converts, the investors could receive shares at a discounted rate. If the worst happens and the company folds, the investor (as a note holder) will be prioritised over shareholders when it comes to splitting assets of the company.

What are the risks or drawbacks of loan notes?

A separate class of shares will need to be considered where conversion is part of the agreement and voting, dividends and distribution rights will need to be negotiated. The default position could otherwise be that the investor becomes equivalent to a founder shareholder in terms of share rights coupled with a high interest rate and large discount meaning they have the majority interest in the company and therefore more control than an individual founder.

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.

Convertible loan notes 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 bankruptcy. 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 convertible loan note will need to be agreed by the board and, if applicable, you will need a special resolution of the shareholders that hold 75% or more of the voting rights to waive pre-emption rights.

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 a sample of 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. Our fees for review start at £600 plus VAT. If we are drafting the loan note or convertible loan note fees will be greater and we will scope and quote.