A-Z of banking and finance: L is for loan notes

Loan notes are widely used: to document deferred consideration in a share sale as "vendor loan notes", as part of a private equity investment structure ("investor loan notes"), to allow for potential future conversion of the loaned amount to equity ("convertible loan notes") or where flexibility for future lending is required but the future lenders are not yet known ("general purpose loan notes"). But what are loan notes, what terms do they include and what advantages do they offer?

What is a loan note?

Like a loan agreement, a loan note details the specific terms of a loan between the issuer (the borrower) and the noteholders (the lenders). Unlike a loan agreement, the loan note instrument is executed by the issuer only: it sets out the terms of issuance of the series of loan notes, capping total issuance at a fixed maximum amount. As and when amounts are advanced by a noteholder on the terms set out in the loan note instrument, the issuer issues a certificate to that noteholder recording the amount issued and that the notes are issued in accordance with the terms and conditions set out in the loan note instrument. 

Loan notes can come in two different forms: registered loan notes where ownership is recorded by the issuer, and bearer loan notes, where ownership is transferred by physically handing over the note. Unsurprisingly, most loan notes at present are registered.

Standard terms

Many of the standard terms included in a loan note instrument will be familiar to those used to loan agreements and include:

• Principal amount: The sum of money lent and which is to be repaid (also known as “redeemed”) at the end of the loan note term by the issuer.
• Interest rate: A fixed or variable interest rate, which the issuer agrees to pay in addition to the principal amount. Interest is typically paid at regular intervals (monthly, quarterly, or annually), but it can also be deferred until the end of the loan note term.
• Maturity date: The date by which the issuer must repay (redeem) the notes in full. Loan notes could be issued for a short-term (maturing within a year) or a long-term (spanning several years).
• Repayment schedule: Loan notes can be structured with flexible repayment schedules, allowing an issuer to make payments according to cash flow or agreed-upon dates or milestones.
• Default: The events which result in the noteholders becoming entitled to accelerate the loan notes and take enforcement action (see: A-Z of banking and finance: E is for Events of Default).
• Credit support: The issuer’s obligations under the loan notes can be guaranteed and/or secured in the same way as a loan can be (see: A-Z of banking and finance: F is for fixed and floating charges and A-Z of banking and finance: G is for guarantee).
• Amendment provisions: Amendments to the loan note instrument will usually require the consent of a specified percentage of the noteholders.

Benefits of loan notes

• Adding lenders:  As long as the prescribed maximum principal amount of the notes has not been reached, additional lenders can subscribe for a loan note on the terms of the loan note instrument without any action required by existing noteholders. This inherent flexibility contrasts with the more laborious process for acceding new lenders to a loan agreement, where a new lender will need to acquire all or part of an existing lender’s commitment.

• Flexibility on amount to be borrowed: The amount borrowed can increase (up to the maximum principal amount set out in the loan note instrument) as and when new noteholders subscribe for notes. Mechanically it can be more complicated to allow for an increasing level of borrowing in a loan agreement.

• Positive tax treatment: Vendor loan notes are issued by a buyer of company shares to the seller as consideration for the share sale. These can help the seller avoid crystallisation of a taxable gain by rolling the gain over into the loan notes.

• Convertibility: Convertible loan notes include an option for the lender to convert the debt into shares in the issuing company, making them particularly attractive in the context of start-ups or high-growth companies. And prior to conversion, convertible loan notes offer noteholders’ down-side protection (remembering that on insolvency repayment of debt ranks ahead of equity) in addition to any rights to enforce security or make demand under any guarantees.

Picking the correct structure

Determining whether to document a loan using a loan note instrument or a loan agreement requires a careful consideration of the specific transaction, and the motivations and risk appetite of the parties.