Convertible Loan Notes

Last Updated: August 10th, 2022

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 an 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.

Convertible loan notes are loans which give 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 the loan is treated as converting into a loan for that non-cash consideration so that it can be treated as paid off.

When are loan notes used?

Loan notes are widely used for business loans. Convertible loan notes are usually unsecured as the lender has the right to subscribe for shares in the borrower.

The advantage of a loan is it gives the lender the opportunity to protect its investment in a way investing by shares do not. In an insolvency situation lenders will be repaid before shareholders.

Investors will often use loan notes for the bulk of its investment alongside smaller equity investment.

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 his investment into shares at the down  round valuation.

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.

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?

If the business cannot afford to pay the loan the convertible loan note holder becomes a creditor with the legal right potentially to wind up the company.  That is the case with a loan which cannot convert so in that respect there is no greater risk with convertible 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.

Cancellation – 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.

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.

Yao Trinh

Manages to explain difficult concepts in easy to understand language. In tune with her clients.

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