Corporate Structuring: Part Two: Convertible Loan Notes

This article constitutes the second in a series of articles which are intended to provide practical overviews of certain structuring tools which provide protection and/or flexibility in transactions.  In this article we will explain convertible loan notes.

One of the most fundamental necessities in ensuring the longevity of any business is access to funding when required, be it to merely survive during difficult trading conditions or undertake planned expansion plans. One lesser known mechanism to undertake any such form of financial restructuring is the use of convertible loan notes as a means of attracting additional investment into a company. In order to properly understand the nature, and ultimately potential application of, convertible loan notes, it is necessary tofirst understand the two most commonly used forms of financing, namely debt and equity investment.

Debt Investment

 Simply put, a debt investment is where funds are borrowed in order to raise finance. Usually the party loaning the funds does so on the basis that there will be fixed dates upon which the amount loaned will be repaid, and there will be some form of agreed monetary based return (such as interest) on the loaned amount. A debt is accordingly created.

Equity Investment

Generally, when people refer to an investment, most of us will immediately think of equity investments.

In such cases the party investing the funds, in return for doing so acquires equity (a shareholding) in the company. Unlike debt investment, there is accordingly no right to repayment of the amount invested and certainly no agreed form of monetary return on the funds invested. The investors only hope of a return will be through dividends accruing from profits generated by the company and possibly some gain if they sell the equity at some time in the future for a higher amount than paid for.

Debt Investment and Equity Investment

 The principal differences between debt and equity investments boil down to certainty and risk. In debt investments, at least to the extent that there is no default, there is greater certainty:

• that the funds invested will be paid back;
• as to when the funds will be repaid; and
• the amount of the return on the investment.

The only real risk on the investor is whether the company will be able to make the repayments due.

In equity investments there is no certainty on any of the above points, even whether an investor will get their money back, and the risk on the investor is accordingly far more substantial.

Considering the above, on the surface of it, it is questionable why any investor would opt for an equity investment with all of its associated uncertainty and risk. The answer is simply that if the investor has faith in the company or a particular path it is following, and believes the value of its equity is going to increase, the potential gains may significantly outweigh the risks involved. What would be ideal would be some form of hybrid between debt and equity investments, and that is precisely where convertible loan notes come in.

Convertible Loan Notes

 As the name suggests, convertible loan notes are loans which are capable of conversion. Convertible loan notes are initially structured as debt investments, usually recording the amount of the debt/loan, the return which will be payable on the debt whilst it exists as a debt, and a repayment timeline. What distinguishes a convertible loan note is that it contains a provision which entitles the note-holder, on terms and conditions and within a time period usually set out in the document, to convert the loan amount (and usually any interest accrued) to equity. The investor/holder of the note therefore has a choice to either keep the relationship as one of a loan (debt), or to convert what is due to him under the loan into equity/shares in the company. A significant component of a convertible loan note is effectively the same as an option (see the previous Galadari article in this series).

Conclusion

The advantages to any investor of investment through means of a convertible loan notes are obvious. The choice whether to keep an investment strictly as debt or whether to convert this to equity lies within the discretion of the investor. Having put funds in as a loan, depending on the time-frame within which an investor has agreed to exercise any conversion right, they can wait and assess the effect of this investment on the company and the value (and projected future value) of its shares and then make an informed decision whether to convert or not.

Although convertible loan notes can be a useful structuring and investment tool, they are not all fit for purpose and their usefulness can differ greatly depending on the particular circumstances and what is sought to be achieved in each case. Professional legal advice should always be sought before entering into any such relationship and the corporate team at Galadari are experienced and more than willing to assist you in doing so.

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