Loan notes and convertible loan notes
Sun 10 December 2023
Loan notes are a type of debt instrument that allows companies to raise capital from investors. They are essentially promissory notes that pledge the company to repay the investor with interest at a specified maturity date. Loan notes can be secured or unsecured, and they can have varying interest rates and repayment terms.
Convertible loan notes
Convertible loan notes (CLNs) can be converted into shares of the company at a specified price. This means that investors have the option to convert their debt into equity if the company's value increases or even as a way to possibly gain control of the company for their own benefit.
Non-convertible loan notes
Non-convertible loan notes are loan notes that do not have the option to be converted into shares. These notes are typically used for more established companies that are not seeking to raise equity capital.
Use of loan notes in UK private companies
Loan notes are a popular financing tool for UK private companies. They are often used to:
- Purchase assets: Loan notes can be used to purchase new equipment or real estate.
- Invest in growth: Loan notes can be used to finance the company's expansion plans.
- Use of loan notes in buying or selling a business -
Why Convertible loan notes are popular
Convertible loan notes are versatile and can often be relatively quickly finalised, and a way for early stage, high growth businesses to raise capital before their initial round of equity financing (seed or series A). On the face of it, convertible loan notes seem a good option for founders because they are not immediately diluted in terms of equity.
Investors also like convertible loan notes because where conversion takes place on the next round of funding there is normally a discount which can be 10-20% or more on the price which other new shareholders will pay.
Convertible loan notes create risks for existing shareholders
The use of convertible loan notes can pose big risks for existing shareholders. These risks include:
- Dilution: The issuance of new shares can dilute the ownership stake of existing shareholders.
- Change in control: If the CLNs are converted into shares, existing shareholders may lose control of the company.
- Common events of automatic repayment including insolvency related events of default or a material breach by the company
Additional rights the lender investor may demand which can be dangerous traps
Everything is negotiable with loan notes and this is a good reason why it’s so important to have experienced lawyers representing you.
Expect that you may be presented with an offer and legal documents which may include some or all of the following enhanced rights (or redemption triggers with penalties if there is any breach) :-
- Redemption trigger with issuing any new shares
- Enhanced rights for lender or penalties for the company if there is a breach of shareholders agreement or articles of association.
- Board representation with no real ability to remove lender nominated directors.
- Veto and control rights over day to day management issues such as recruitment, buying equipment or other financial expenditure.
- Pre-emption rights on issuing new shares or on exit of founders shares.