Convertible Loan Notes – meaning in practice
Convertible loan notes seem too good to be true. Convertible loan notes are simpler, quicker, cheaper and offer more flexibility than shares. They allow pre-valuation investment and the founders keep control… The question is for how long and what are the eventual consequences of such an easy cash injection?
Caveat Emptor entrepreneurs! The small print isn’t so small when the provisions allow the taking over, or worse, the shutting down of your business. Our review of a convertible loan note agreement starts at £750 plus VAT.
Convertible loan notes are, initially, debt rather than equity. Upon insolvency debt is paid off before equity. This is the big attraction for investors.
We have acted on many convertible loan notes that have provided flexibility to the investor and the business. However if the investor is EIS convertible loan notes are not possible. But for non-EIS investors convertible loan notes are becoming more and more favoured over other methods of investment. This is because they offer an additional level of protection and choice as to whether to convert to equity.
The problems with convertible loan notes
Convertible loan note investors, when the loan is converted, get their loan plus interest converted into equity at a discounted rate. Conversion can leave the shareholders giving away significantly more equity in the Company than envisaged depending on the agreed conversion and rates. This could affect future investors as the convertible loan note could be a disproportionately large portion of the investment round and leave the existing investor as potentially the largest shareholder in the Company following conversion.
New investment rounds
Convertible loans will often be convertible on a ‘qualifying round’, giving the convertible loan note holder the opportunity on a down round, where new investment is achieved at a price that is less than the hurdle/threshold the existing investor has set to cash in by taking shares at the down round valuation.
There will often be default conversion provisions triggered by, for example, a long stop date, a (usually long) list of breaches, change of control etc.
There will often be redemption provisions, where the same 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 start up business.
If the business cannot afford to pay the convertible loan note holder becomes a creditor with right potentially to wind up the company. In some cases, the directors are required to provide guarantees as to payment – default can give rise to personal bankruptcy. Often the loan note holder reserves the right to appoint administrators.
Loan notes can be a false positive
The simplicity and flexibility of convertible loan notes is in some ways a false positive, these terms will still need to be agreed between the parties so that provision can be made for conversion. This means that the separate class and negotiations over 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.
Convertible loan note agreements do need reviewing both from the legal perspective and the financial ability to pay taking into account worst case scenarios.