Convertible loan notes are a hybrid form of debt finance, where funders offer a company an interest-bearing, repayable loan that’s convertible into that company’s shares at their discretion, or upon the occurrence of certain events. They’re a way for a company to raise finance quickly, and ahead of full equity funding rounds. Convertible notes offer investors the chance to acquire shares during a subsequent funding round at a discounted price.
While convertible loan notes can be a good option for borrowers, since the interest payable is typically lower than on a standard loan and they’re simpler to set up than equity investment, they can sometimes attract negative tax consequences for both the borrower and the investors.
Read our guide below for more information on convertible loan notes and how they could work for your business.
- What’s a convertible loan note?
- What’s a convertible bond?
- What’s the difference between a convertible bond and an exchangeable bond?
- Why would a company issue convertible debt?
- When will a convertible loan note convert to equity?
- What do you need to know about the key points of conversion?
- What is the conversion formula?
- Does the loan in a convertible loan note need to be repaid?
- What are the disadvantages of a convertible loan note?
- Looking to raise investment?
What’s a convertible loan note?
A convertible loan note is a type of debt ‘instrument’, i.e. a document that represents a loan made to a company. The note is ‘issued’ by the borrower and held by the lenders (or investors). Convertible loan notes are different from ordinary debt as they are convertible into the company’s shares (its equity). In the context of venture capital funding, convertible loan notes are typically issued as a short-term bridge facility ahead of a venture capital funding round.
A loan note represents a single debt and can be issued to single or multiple lenders. The debt is evidenced by a loan note certificate that describes the noteholder’s share of the company’s debt.
For larger loan note programmes, a trustee is normally appointed to administer the convertible note. The borrowing company issues a single loan note to the trustee who acts on behalf of the investors.
Convertible loan notes may be secured or unsecured, publicly listed or unlisted. Sometimes convertible loan notes are used as a form of deferred payment (instead of cash) in the context of a company acquisition.
Convertible loan notes give the holders the right to convert the loan into the company’s shares, at their discretion.
What’s a convertible bond?
A convertible bond is another name for a convertible loan note.
What’s the difference between a convertible bond and an exchangeable bond?
A convertible bond gives the bondholder the option of converting its bond into newly issued shares of the borrowing company. An exchangeable bond gives the bondholder the option of exchanging its bond for existing securities of a different company (normally a subsidiary company of the borrower).
Why would a company issue convertible debt?
A company may consider convertible debt either for general funding or for a specific objective such as an acquisition.
Because of their convertible nature, borrowers who issue convertible debt will generally pay a lower rate of interest on the debt than they would under a conventional loan, thus reducing their costs of borrowing.
What’s more, in comparison to raising finance by issuing shares to investors in return for finance, since the bond or noteholders aren’t shareholders, they won’t have any voting rights and so won’t exercise any influence over the company’s operations.
It’s usually less hassle for a company to issue convertible loan notes rather than offer investors shares. They’re easier to set up, require fewer documents, and are simpler to negotiate than equity financing. These factors allow companies to raise money quickly and minimise costs, particularly since the negotiations around the valuation of the business may be able to be postponed until a full equity funding round or until certain commercial milestones are achieved.
For the funders, their convertible debt ranks ahead of shares in insolvency, so they’re a safer investment than equity. Furthermore, if the company does well, the lenders can convert their debt into shares, enabling them to benefit from a company’s increase in value.
For specific objectives such as an acquisition, a company may offer the sellers convertible debt as part of the purchase price.
When will a convertible loan note convert to equity?
A convertible loan note will typically convert to shares if a company is sold or completes a successful round of full equity funding.
The price that the noteholders will pay for their shares is normally less than the price that outside investors will pay during the funding round because they’re offered at a discount. For example, if investors are subscribing for shares at £1 per share, a convertible loan note may convert at a price of 80p per share.
If the conversion trigger is a further equity funding round, the funders will usually convert their debt into the most senior class of shares offered during that round. Funders may also have the option to convert their debt into an existing class of shares at a pre-agreed price if an equity funding round does not occur.
A company will usually pay interest on its convertible debt at a rate of between 4% and 8% per annum. However, in reality, interest is rarely paid but rather deferred or ‘rolled-up’ into the amount to be repaid or converted into equity.
What do you need to know about the key points of conversion?
Convertible loan notes may convert into shares automatically following certain events, or they convert at the discretion of the funder. The conversion conditions will be contained in the convertible loan note instrument.
Common automatic conversion events include the company raising finance above a certain threshold by a certain date, or the company being sold.
Common discretionary conversion events include the company raising finance below the amount originally envisaged, or if the investor chooses to convert the loan note into equity.
You should be aware that when a loan note converts, the loan note investors are likely to get similar rights to the new investors but pay less for the shares. In addition, it might be more difficult to raise finance in the future via equity funding, as potential new investors may be deterred from investing where a significant proportion of the shares will be held by the loan note investors.
What is the conversion formula?
The conversion formula where loan notes convert to shares is normally at a percentage discount to the price offered to new investors. The loan notes will normally convert into the same class of shares as the new shares, but the investor will receive slightly more shares than the face value of the notes would imply. This is expressed as a percentage discount (e.g. 10%) to the price paid per share in the new financing.
The discount rewards the investor for investing in the loan notes and for providing a bridge facility to the company.
If a company’s sold, and that triggers the conversion, a common conversion formula is for the loan notes to convert into shares at a previously agreed price per share. The company must agree the valuation at which the loan notes convert to shares at the time the loan notes are created.
An investor may wish to include a threshold valuation for the company as security before automatic conversion. Alternatively, an investor may make conversion at its discretion, to avoid holding substantial equity in a company valued less than it originally envisaged.
Does the loan in a convertible loan note need to be repaid?
If a convertible loan note never gets converted into equity, the funder(s) will need your company to repay the loan. However, if the loan note is converted into equity then no further repayment will be required.
The repayment condition may be either automatic or at the choice of the investor. Common events of automatic repayment include:
- Insolvency related events of default
- Failure to repay or convert before a set date
- A material breach by the company
If an automatic repayment event is triggered, the notes will have to be repaid immediately.
The loan note instrument may also provide that the loan notes are to be repaid if the company does not achieve the requisite level of financing within an agreed timeframe. This sort of repayment is normally at the election of the investor.
It’s common for loan notes to be repayable at the nominal amount of the loan notes outstanding plus the interest accrued on the loan notes during the term of the loan.
What are the disadvantages of a convertible loan note?
A key disadvantage with convertible loan notes is that several major tax reliefs for investors are not available. For example, the Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) only apply where an investor invests in a company’s equity as opposed to making loans, even if they’re convertible into shares. This means that investors could miss out on as much as 50% income tax relief on the amount invested when investing in convertible loan notes rather than in shares.
Furthermore, if you’re a personal or private equity investor, convertible bonds issued as bridging loans can also sometimes be taxed as deep-discounted bonds if they carry a high interest rate or redemption premium. This can create income tax charges on conversion so you should take specialist tax advice before proceeding.
Looking to raise investment?
If you’re an entrepreneur looking to raise finance for your business, you may be considering onboarding an investor such as venture capital or private equity firm. If that’s the case, you’ll most likely come across a variety of different legal documents as part of the funding transaction, one of which is an investment agreement. Find more about investment agreements and how they are used in our FAQ article.