Loan notes can play a significant role in providing companies with a flexible option to raise capital, and investors with an opportunity to earn returns on their investment potentially more easily than issuing investors with shares and declaring dividends. However, navigating the complexities of loan notes requires a thorough understanding of the legal intricacies involved. This is where the expertise of a solicitor with experience in dealing with loan notes proves invaluable. The Corporate and Commercial Team at Savage Silk has dealt with numerous loan note transactions so are well versed in the process.
What are loan notes?
Loan notes are commonly used to raise funds for a wide range of projects usually because they are seen as quicker to implement than traditional forms of lending. Loan notes are essentially an IOU by the company to the lender promising to pay a sum of money to the lender on a specific date with interest. The main document used is the loan note agreement which is essentially an agreement between the borrower company and the lender/investor which sets out the terms on which the investor agrees to make a loan to a company in return for repayment on an agreed date with interest.
Will the loan notes be convertible?
Sometimes the loan notes are “convertible.” This means that if the loan is not repaid on the due date, the amount of the loan notes is ‘converted’ into shares in the borrower company. E.g., if the loan is for £100,000 the lender would get £100,000 worth of shares in the company if the £100,000 and the interest is not paid on the due date.
The value of the shares is usually determined at the due date, so the loan note agreement needs to contain mechanisms regarding valuation of the shares. For example, a clause should be included which states that the company is not permitted to do anything which artificially inflates the value of the shares because that would result in the lender obtaining fewer shares. For example, in the above scenario, if each share was inflated so that it was worth £25,000, the lender would only obtain four shares (100,000 / 25,000). That would mean that any dividend paid on the shares would be less because dividends are paid as an amount per share so if the fewer shares you have the less your total dividend will be.
If the loan notes are convertible, what class of share will the lender receive if the loan is not repaid on the due date?
The borrower company may have different classes of shares (such as A shares, B shares etc.) Each class of share will have different rights attached to it (e.g., voting rights and rights to dividends).
It is important that the loan note agreement sets out the class of share that the lender will obtain if the loan is not repaid so they know what their rights as a shareholder will be before they loan the money to the company.
What do the articles of association and any shareholders’ agreement say?
The articles of association of the company are the company’s internal rules governing how it has to conduct its operations. When someone takes shares in the company, they become bound by the company’s articles. Similarly, if the company has a shareholders’ agreement (which is a private contract between the company and the company’s shareholders), any new shareholder would be required to sign up to that as well and abide by its terms.
Before making the loan to the company therefore, the lender needs to know what the articles and any shareholders’ agreement say because, if the loan notes are converted into shares, they will be obliged to comply with the articles and the shareholders’ agreement in the way that a normal shareholder would be.
Will the loan notes be secured?
We all know of situations where companies have become insolvent. If that happens the lender is highly unlikely to be repaid their loan and any shares they receive in the company, as a result of the loan notes being convertible, would be worthless.
The lender can therefore, in addition to the loan note agreement, obtain security (such as a legal charge over a property the borrower company owns and/or a debenture over the company’s assets) to make it more likely that their loan will be repaid.
If that is to be the case, then the terms of any prior legal charges and/or security the company has in place will need to be reviewed and the consent of any prior lender obtained before the charge in favour of the lender is granted.
Conducting Due Diligence
A thorough due diligence process is essential before entering into any financial agreement including a loan note agreement so that the lender knows of the financial situation of the borrower company before it makes the loan and its ability to repay it.
Our team works with the lender and its accountants to ensure that it has peace of mind before entering into the documents and loaning the company the money. Or, if we are acting for the borrower company, we can work with that company to ensure that the due diligence queries raised by the lender are answered clearly, fully and timely to prevent delays in the loan being made.
If you need assistance with your loan note agreements, please contact the corporate and commercial team at Savage Silk on 0345 209 4700.
Please note that this article is for information purposes only and it is not intended to be legal advice. It is always advisable to obtain independent legal advice from a solicitor before you sign any documentation.
Chris Morgan, Senior Associate, Corporate and Commercial