Everything You Need To Know About Convertible Loan Notes
By Pádraig Walsh, Last updated: 2021-09-06 (originally published on 2019-07-12)
My present favourite startup financing document is the convertible loan note. Ask me next week, and it will be something else. The convertible loan note has enough good points for founders and investors to benefit both sides. So, let me summarise the key features of a Convertible Loan Note, and why it’s my current fave.
What is a Loan Note?
A Loan Note is a record of the terms for a loan. It is like a promissory note or an IOU, but with more detail.
If a Loan Note is a record of a loan, does this mean the Loan Note is prepared after a loan has been received?
No. The sequence is this:
The company will approve and issue a Loan Note Instrument. This will set out the standard terms on which the company is seeking a series of loans up to a maximum desired loan financing amount. The Loan Note is approved by the company, and then issued to potential lenders.
If lenders find the terms of the Loan Note agreeable, they will apply to the company for the right to advance loans under the Loan Note. If the company approves a loan allocation to a lender, then the terms of that specific loan are recorded in a loan certificate. The loan certificate is given to the lender after the loan has been received by the company.
So the lending terms are known before the loan is made, but the record of each individual loan is given after the loan is made.
Is a Loan Note the same as a Loan Agreement?
A Loan Agreement is signed by both parties, and contains the negotiated terms for borrowing agreed by those parties.
A Loan Note is issued by the company taking the loan, and does not need to be signed by both parties.
Normally, the terms of a Loan Agreement are more detailed and complex than a Loan Note, as they represent the fully negotiated, bilateral lending terms specifically agreed by the two parties.
If only one party signs, is a Loan Note enforceable?
Yes. The general requirements for a contract are offer, acceptance, commercial benefit, an intention to create legal relations, and certainty of terms. All these elements are present in a Loan Note issuance.
The company issuing the Loan Note makes an offer by approving the Loan Note, and issuing it to prospective lenders. Lenders agree to those terms by the act of advancing a loan in accordance with the Loan Note. The terms of the loan are clearly set out in the loan certificate issued by the company on receipt of the loan.
What is a Convertible Loan Note?
A Convertible Loan Note allows shares in the company to be issued, instead of repaying the loan.
Technically, the Loan Note will be redeemed and cancelled, and the lender will direct the repayment amount to be applied solely for the issuance of shares in the company. It is a cashless transaction which is authorised in the Loan Note itself, if a conversion event occurs.
When will a loan convert to equity in a Convertible Loan Note?
The loan will convert to equity on conversions events that are set out in the terms of the Convertible Loan Note. Conversion can occur automatically or by giving notice. The normal automatic conversion events are:
1. An equity financing round: This will require the loan to convert to equity immediately before the next equity financing round of the company. Founders should set a qualifying financial limit on the capital raised in an equity financing rounder before conversion is triggered. This avoids conversion occurring for a small equity round.
2. A liquidity event: This will require the loan to convert to equity immediately before a liquidity event occurs to the company. The most likely liquidity events are a sale of shares or merger of the company that result in a change in control, or a sale of substantially all assets of the company. More optimistically, an IPO would be a liquidity event; more pessimistically, so is winding up and liquidation.
Does the loan in a Convertible Loan Note need to be repaid?
If the loan is not converted to equity, then the loan must be repaid either on the maturity date or on demand after an event of default.
What is the relevance of the maturity date?
The maturity date crystallises the obligation to repay the loan amount. Failure to pay on the maturity date is an act of default. This would give the lender the right to issue legal proceedings for repayment. Also, interest, or a higher default interest rate, is often applied to the loan amount from the maturity date onwards.
The Convertible Loan Note could provide that the loan will convert to equity on the maturity date. If so, the terms should make clear whether the conversion is automatic or by notice. If the conversion is by notice, the terms should make clear who has the right to give notice of conversion.
Founders should try to have the maturity date as distant as possible from the date of the loan. In Hong Kong, investors typically seek one year; two years (or longer) would be favourable to founders.
Is interest charged on the loan in a Convertible Loan Note?
This is negotiable, and market practice varies. In startup financing, it is common to see interest-free Convertible Loan Notes, with interest being charged from the maturity date or a default event. Interest is equally common though. After all, a loan is involved.
What are the key points about conversion to think about?
Here are some points to consider:
1. Share class: Check the share class from which the conversion shares will be issued. Founders should provide that conversion shares are issued in the same ordinary share class as founders. Investors will want the conversion shares to be issued in the most senior class at this time of conversion. This will give the investors the same share rights as other investors in the equity financing. Those rights would typically include a liquidation preference, and other rights that dilute founders.
Conversion formula: The conversion terms will provide for a conversion formula. Investors will look for favourable terms to provide upside for agreeing to finance the company earlier than an equity financing round. The favourable terms will result in more dilution to founders on conversion.
What is the normal conversion formula used in Convertible Loan Notes?
There are two common methods:
1. Discount method: This will state a percentage discount to the price per share in the equity financing round. This negotiable, but the range in the Hong Kong market varies from 8% to 20%.
2. Valuation method: The pre-money price per share of a company is calculated by dividing the overall valuation of the company by the shares in issue. Normally (but not always), the shares in issue would be calculated on a fully diluted basis. A valuation cap imposes a ceiling on the valuation of the company in that calculation. So, if there is a valuation cap of US$1 million in a Convertible Loan Note and the actual pre-money valuation of the company is US$1.5 million, then the number of conversion shares under the Convertible Loan Note will be based on the valuation cap of US$1 million. This will result in more shares being issued to the investor, than if he had invested at the time of the equity financing round.
Investors will want to benefit from the more favourable of these methods.
Founders should familiarise themselves with both these conversion methods. The dynamics of the valuation cap are particularly critical. A poorly judged valuation cap may complicate equity financing, as later investors may believe too much benefit has been given in the Convertible Loan Note.
What other terms are there in a Convertible Loan Note?
Other common terms include:
1. Noteholder rights: These are rights of the investor in respect of the affairs of the company until the conversion or repayment of the loan. Common noteholder rights include:
(a) information rights in respect of the accounts and budgets of the company; and
(b) prohibitions on changes to the rights of noteholders.
Investors may wish to have other protections. For instance, investors may want to have approvals for key decisions by the company. Or investors may stipulate provisions that must be reflected in the Shareholder Agreement for shares to be issued to them on conversion. Founders should try to resist these requests in early stage financing.
2. Novation and reorganisation: It is quite common for a corporate restructure to occur between the issuance and conversion of a Convertible Loan Note. For instance, a Convertible Loan Note may be issued by a Hong Kong incorporated company. Investors in the subsequent equity round may insist they invest in a company incorporated in another location – such as Delaware, the British Virgin Islands or the Cayman Islands. The Convertible Loan Note will usually provide a mechanism under which it may be novated and transferred to the new holding company. This allows the equity conversion to occur in respect of the new holding company.
3. Assignment: Founders should always ensure that there is a restriction on assignment of the Convertible Loan Note. This must be expressly stated in the terms; it will not be implied. The restriction should require the consent of the company to any assignment of the Convertible Loan Note by the investor. This is important as otherwise, founders could find themselves with persons holding shares in the company whom they have not approved. Also, if the Convertible Loan Note was freely assignable, then it would be considered a security under Hong Kong law. This would impose a higher standard of regulation.
What does a Convertible Loan Note look like?
A Convertible Loan Note will have two parts:
1. Convertible Loan Note Instrument: This document is a framework instrument. It sets out the terms that apply to all Notes issued in the series. Those terms will include:
(a) total loan amount to be raised;
(b) minimum loan amount for each Note;
(c) noteholder rights;
(d) reorganisation provisions; and
(e) assignment restrictions.
2. Note Certificate: This document is the record of each loan received from each investor in the series. The Certificate will:
(a) state it is subject to the Convertible Loan Note Instrument;
(b) set out how much has been advanced by that investor;
(c) set out the terms of repayment or redemption of the note; and
(d) set out the terms of conversion of the note to equity.
These are the documents used for issuing a series of Notes to investors on the same terms. A company can also issue a Convertible Loan Agreement with a single investor, or with investors on a case-by-case basis.
How is a Convertible Loan Note approved?
A Convertible Loan Note issued by a Hong Kong incorporated company should be approved by an ordinary resolution of the shareholders of the company, and by its board of directors. Founders should also ensure that no other approvals are needed – for instance, under a shareholder agreement or other contractual arrangement.
Different approval requirements may apply for companies incorporated in other locations.
What filing requirements are required in respect of issuing a Convertible Loan Note?
There is no requirement to make any filing with the Companies Registry in Hong Kong in respect of the issuance of a Convertible Loan Note. Filings will be required for the issue and allotment of new shares on conversion of the loan to equity.
As a matter of good practice, the company should maintain a register of convertible rights (convertible loan notes, share options, and similar instruments). This will ensure it has an accurate record of rights that may convert to equity. This is not a statutory requirement.
Is a Convertible Loan Note a security?
A Convertible Loan Note issued by a Hong Kong incorporated company will not be considered a security, provided it specifically provides that it is not negotiable or transferable.
Why is a Convertible Loan Note attractive for founders?
The reasons why founders may consider a Convertible Loan Note favourably include:
1. In a Convertible Loan Note series, the company sets the terms and those terms will be standard across all lenders. This helps founders to agree more favourable terms.
2. The company has the right to repay the loan. If so, the loan will not convert to equity, the lender will not become a shareholder of the company, and founders will not be diluted.
3. The terms of a Convertible Loan Note are quite straightforward. There are not many variables to consider or negotiate. Financing can be achieved quite quickly, once willing investors are confirmed.
Why is a Convertible Loan Note attractive for investors?
The reasons why investors may consider a Convertible Loan Note favourably include:
1. The investors can negotiate favourable investment terms by negotiating the cap and discount to apply on conversion. They get more upside.
2. Often, the loan will convert into the most senior share class. Investors on a convertible loan note get the upside of the best available terms on the equity round, without having to negotiate those terms.
3. The investors can consider whether it wishes to charge interest on the loan, or other favourable terms.
4. The investors will achieve a higher priority to founders if the company fails. The loan is a debt. Debt is paid in priority to the claims of shareholders in a liquidation.
Padraig Walsh is a Partner at Tanner DeWitt specialising in Corporate & Commercial, Financial Services Regulation, Notarial Services. Thank you for reading. Find out more about what I do here.
This article is provided for general information only. It does not contain legal advice, is not intended to provide legal advice, and none of its content should be relied upon as legal advice. You should not act or refrain from acting on any content in this article without seeking appropriate legal or other professional advice on your particular circumstances.