Convertible loan notes: A brief summary
Apr 24, 2017
Author: Graham Halliday
Instead of going straight into an equity funding round (i.e. the issue of shares in exchange for funds) some companies initially raise money through a type of debt funding, known as convertible loan notes, in order to prove a concept, start trading or to stay afloat. They are also used at later stages as bridging finance in order to keep a company trading in anticipation of a sale or listing. However, this note focusses on the first use. I have provided a brief summary of what a convertible loan note is and their advantages, disadvantages and common terms.
What is a convertible loan note?
Convertible loan notes are essentially loans which bear interest and are repayable at some point in the future, except that they convert into equity (i.e. shares in the borrower company) in certain circumstances (usually a future equity funding round or a sale of the company). This is essentially the whole point of a convertible loan note.
Why use a convertible loan note?
As there is usually less documentation to negotiate in comparison to a normal equity investment, they are typically used where a company is looking to raise money quickly, usually to prove a concept, in anticipation of an equity funding round in the near future. This also allows companies to minimise the costs of raising money when budgets are tight.
What are the advantages to the founders of the borrower company?
In addition to allowing companies to raise money quickly, they also allow the company and the loan note investor to delay negotiating the valuation of the company until the first equity round. If a company is not yet profitable (or hasn’t even started trading), it may be difficult to value the company. The founders can therefore hold off negotiating the value of the company until it is in a stronger position and avoid potentially giving away too much equity at an early stage.
What are the advantages to the investor?
Convertible loan notes are often viewed as giving investors the best of both worlds. On the one hand, if the company’s fortunes decline and the company becomes insolvent they (and the other creditors) will rank ahead of the shareholders and will have priority over the shareholders in respect of the assets of the company. On the other hand, if the company’s value grows and, for example, it receives a large equity investment, the loan note investor can convert the loan into equity at a discounted rate to the new investors. They usually also benefit from the preferential rights that the new investors receive under this equity funding round.
Under what circumstances do notes usually convert?
As mentioned above, the idea behind convertible loan notes is that they should convert into equity at some point in the future. They typically convert automatically on a qualifying funding round (as explained below) or a sale of the company. Sometimes the loan note investors also have the option of the loan notes converting or becoming repayable on a maturity date (e.g. if a qualifying funding round hasn’t occurred within 2 years of the loan being made) or on a non-qualifying funding round (as explained below).
A qualifying funding round is where the company achieves new investment in excess of an agreed amount before an agreed date e.g. raising £2 million within 2 years of the loan note. On a qualifying funding round the notes usually automatically convert at a discount into the most senior class of share issued in the funding round. For example, if the new investors are subscribing for shares at £1.00 and the loan note investors have a 20% discount, their loans will convert at £0.80 per share. This eliminates the debt and rewards the loan note investors with a discounted price per share.
A non-qualifying funding round is where the pre-agreed fund raising amount is not achieved within the agreed time. As the objective is not met, the loan note investors can choose to convert their shares at a discount or wait until a qualifying funding round where, for example, the loan note investors are happy with the rights attaching to the shares to be issued under that round.
What are the common terms relating to the conversion of the notes?
- Class of share on conversion: As mentioned above, when the loan converts on a funding round the class of shares issued to the loan note investors is usually the most senior class under the fund raising round. This is typically preferred shares with preferential rights to the ordinary shares on the liquidation and sale of the company.
- Discount: The loan notes also usually convert at a discount to the price per share on the equity funding round to compensate the risk the loan note investors have taken with their money. This discount is usually between 10% and 30% and is one of the key terms to negotiate.
- Valuation cap: As a high valuation of the company could give the loan note investors an insignificant percentage of the company’s share capital following conversion, a valuation cap on a qualifying funding round guaranteeing the loan note investor a minimum percentage of equity if the company’s valuation is extremely high is sometimes included. For example, a loan note investor could be guaranteed at least 5% of equity if the company is valued at £20 million or more. However, including a cap means that discussions will need to be had over the company’s valuation, which can make negotiations protracted and to some extent undermine one of the key advantages of convertible notes.
- Interest rate: Convertible loan notes usually accumulate interest in the same way as normal loans. The interest rate on a convertible note is usually between 4 and 8%. Sometimes the interest converts but it is usually only payable on redemption.
Under what circumstances are notes usually redeemed (i.e. when is the loan is paid back)?
When loan notes are redeemed the loan becomes repayable and the loan will not convert into equity. Usually, the loan note investor can redeem their loan notes if they have not converted into equity by a certain date (e.g. if a qualifying funding round has not taken place within two years). The loan note investors also usually have the right to redeem the loan notes on a non-qualifying fund raising round (as explained above) or if the company becomes insolvent.
What are the disadvantages of convertible loan notes?
Founders should be aware that when the loan note converts at the next funding round the loan note investors are likely to get similar rights to the new investors in that round. These rights may be more favourable than those the loan notes investors would have received had they invested in shares.
In respect of investors, loan notes do not enable them to benefit from Seed Enterprise Investment Scheme (SEIS) relief or Enterprise Investment Scheme (EIS) relief at present, both of which are very valuable to business angels. This is one of the main reasons why convertible loan notes are not used in the UK as much as in the US.
In any case, if a company decides to raise money by issuing loan notes, it is important to carefully consider the impact on raising money under a proper equity round in the future. Equity investors can be put off from investing under an equity funding round if, for example, loan notes will make up a significant proportion of the equity funding round and/or if the loan note investors are entitled to a large discount on their shares. If the loan notes make up a significant proportion of the equity funding round, then a large amount of equity could be given away under the round whilst a comparatively small amount of money is being raised, which can be unattractive to potential new investors. It is therefore important for the company to consider the timing of the convertible loan notes in relation a future equity funding round and how the share capital of the company could look after conversion of the notes.
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Specialises in Corporate Law
Graham has experience in advising clients on Corporate Law matters, mainly split between M&A transactions and venture capital investments. These transactions are mainly focussed around businesses in the IT, technology and digital media sector. Graham also has experience in setting up EMI options schemes. His experience of working with a start-up prior to entering the law has given him an in-depth understanding of the issues which entrepreneurs and start-ups face. Read more...