Being able to box clever with your credit and debt is the key to harmonious business finances. A lifetime of household budgeting and debt management can make us unduly averse to debt in our entrepreneurial lives. But debt is not a rude word. Debt can be instrumental in helping you make capital investments that take your company to the next level. It’s simply a matter of borrowing on terms that are advantageous to your business, and being able to know good credit from bad. Which brings us to loan notes (also known as promissory notes).
Here we’ll explain how loan notes work, and how they can be beneficial for your business.
What is a loan note?
A loan note is much the same as an IOU / bill of exchange. It is an agreement between a company and an investor whereby the investor agrees to make a loan to a company, and the company agrees to repay the loan by an agreed date, usually with interest added on. Payees are often provided in lieu of cash, at the request of the payee. They can be secured against an asset, although there is no requirement for them to be.
A loan note requires the legal obligations of both the lender and borrower to be established and agreed upon such as the principal amount, due date, payment schedule and interest rate, as well as any prepayment fees the lender wants to implement.
Loan notes can be a promising source of seed capital for new startups, and come with some appealing tax benefits.
As well as using loan notes to finance their businesses, companies can also leverage loan notes for substantial purchases. Car finance agreements and mortgages, for instance, are common examples where loan notes are used.
What are convertible loan notes?
A convertible loan note can be converted into equity at a specific time or when a predetermined event occurs. Businesses often use convertible loan notes when they need quick access to liquidity.
A convertible loan note must clearly delineate the parameters for a “conversion event” such as a change of control or the raising of funds to a predetermined amount. There is usually also a formula included for converting to shares at a discount.
It may also be advisable to establish provisions whereby the loan can be repaid without the conversion taking place.
What are the benefits of a loan note?
A loan note can offer greater flexibility than a simple loan agreement, while still being legally actionable should it need to be upheld in court. They are also much easier to enforce than an informal IOU because the legal terms of the agreement are much more clearly defined.
A loan note is fairly quick, easy and convenient to draw up, and can facilitate borrowing from multiple creditors under the same note. They are advantageous to emerging new businesses as they can give them the capital they need without having to part with any of their equity. Or at least from having to part with any equity upfront.
They also represent a degree of reassurance for investors, as they ensure that debt is paid off before a company reaches insolvency. They can also have tax advantages, as they can insulate individuals from the tax liability that can come with a lump-sum payment or cash package.
We can help
If you’re interested in finding out more about loan notes, smarter borrowing options, or any other aspect of your business finances, then get in touch with our financial experts. Find out how GoCardless can help you with ad hoc payments or recurring payments.