Why loan notes may be better than simple loans for your business
What is a loan note?
A loan note is an IOU from a company to an investor. The investor agrees to make a loan to the company and the company agrees to repay it at a future date, usually with interest. A loan note is a financial instrument which, in its simplest terms, evidences a debt between the borrower (commonly known as the issuer) and one or more lenders (commonly known as loan noteholders). It is an agreement to repay debt between the parties at a future point in time. However, loan note instruments are usually more complicated than a simple loan agreement and can include multiple lenders (although they can be between two parties) and often include more complicated repayment terms.
How a loan note works
A loan note instrument sets out the terms and conditions relating to the debt and is usually a fairly lengthy document. It will, for example, usually contain provisions to govern when the debt is to be repaid, the interest that accrues, events of default and any conversion terms. Loan notes can be transferred if the terms and conditions of issue permit it, but otherwise there is no entitlement to do so.
The noteholders will be issued with loan note certificates evidencing the loan notes they hold and the certificate will also set out some of the key provisions relating to the money lent. A company does not have to keep a register of the loan note holders as part of its statutory registers (unless the loan notes are secured) but some companies choose to, as a matter of good corporate governance.
Why choose a loan note instrument rather than a simple loan agreement?
- Loan notes can be a good way for a business to get funding without giving away equity (either at all, or at least up front). Loan notes are often structured in such a way as to be convertible, meaning that equity may be given away at a future point and upon a certain event
- They can offer more flexibility and are good for investors as debt is paid off before insolvency (in the unfortunate event that this happens).
- As mentioned above, they are also an easy way to issue notes to numerous loan noteholders.
What about convertible loan notes?
These are loan notes which can convert into equity upon a future event or at a specific point in time and are often used when a company needs money quickly. The instrument should specifically set out the following:
Conversion event – i.e. when the loan notes will convert into equity- typical examples being on a fundraising round that raises a set amount or upon a change of control. It is also important to consider if there should be a longstop date on the conversion, and if so, when this should be.
Conversion discount – often there is a formula included for the calculation to convert the debt into shares (this is usually linked to the amount raised and therefore there may be different calculations depending on the level of money raised in the funding round). The shares are usually converted at a discount to the purchase price paid by the new equity investors in the funding round. Depending on the level of discount, other terms in the loan note instrument may be more or less favourable.
Repayment – it is important to consider if there are to be provisions to allow the loan to be repaid without the conversion taking place.
What are vendor loan notes?
When a company is sold, loan notes can be issued by the buyer of the company’s shares to the seller as consideration for the shares instead of cash. There are often tax benefits for the seller in accepting loan notes. This is a form of deferred payment as the seller is not receiving all of the cash proceeds up front. Sellers who receive these loan notes may avoid crystallising a taxable gain as it rolls over into the loan notes. Whether such deferral is beneficial will depend on the individual seller’s ability to claim entrepreneurs’ tax relief.
Can loan notes be secured?
Obligations under loan notes can be secured but there is no requirement for them to be. Security may be taken over all the assets of the issuer or over certain key assets. If they are to be secured, the instrument will usually include a statement confirming this. Often if there are multiple loan noteholders and the notes are secured, a security agent is appointed as the security trustee. Terms are often contained in a security trust deed but the security trustee has a duty to enforce the security in accordance with instructions of the noteholders.
If the loan notes are secured by a debenture, this should be contained in a separate document and filed at Companies House.
Please contact the Trowers’ team for more information. We have also produced a series of fact sheets to help you, so click here to access our online resources.