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Loan Notes for Investors: Are They Becoming More Popular?

Posted on Jun 26, 2012 by Kenny Mumford  | 0 Comments

By Kenny Mumford

Over the past eighteen months or so, I have noticed a clear trend developing in the world of early-stage investment as UK angel investors increasingly use loan note investments to finance businesses. Debt finance by business angels has become more popular in the US in recent years but the tax incentives that are available in the UK – specifically EIS relief – mean that equity remains the most common way for angels to invest in this country. 

Since the introduction of EIS relief, loan note investment by UK angels has largely been limited to bridging finance. However, it now seems that this “bridging” idea is being extended to helping a company over the gap in seed finance, pending a larger first round of equity investment.  It’s also unlikely that this trend is evolving in complete isolation from the lack of bank financing for early stage companies. 

Although they surrender the EIS tax incentives, UK angels using loan notes can benefit from:

  • Ranking as a creditor rather than as shareholder – this gives the angel a clearer prospect of getting their money back;
  • An agreed rate of interest or redemption premium;
  • Simplified due diligence and transaction documentation;
  • Avoiding the need to value the business; 
  • Taking some form of security over the company’s assets (in certain instances); and
  • Lower deal costs due to simplification.

While this all sounds attractive, it’s important to remember however that by using a very simple loan note, investors also lose out on the opportunity to make the kind of large gain that brings them into the investment market in the first place. As a result, most of the loan note investments I see also carry a convertible element, which allows the investor to convert their loan in to equity at some point in the future on pre-agreed terms.

It is in these conversion terms that some caution really needs to be exercised. While it might be possible to allow conversion at a pre-agreed discount to a future fundraising price (which effectively parks the question of valuation to another day), almost all other conversion scenarios can quickly lead back to the valuation question or can lead to assumptions being drafted into the loan note documentation which, on closer scrutiny, have the potential to be very prejudicial to the company and its existing shareholders.

So if you’re considering using convertible loan notes, the message is that they can be made to work for both parties - but with the desire for a quick and simple deal, you should be careful to ensure that you do not let the impact on equity be overlooked entirely.

kenny.mumford@mbmcommercial.co.uk

0131 226 8205

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