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If you own a startup and want to raise growth financing, you may have encountered both loans and loan notes. Both loans and loan notes are forms of debt financing. Loans typically describe traditional bank loans between you and at least another bank or specialist lender. On the other hand, loan notes are more like shares that your company issues to multiple investors. However, they function like any other borrowing because your startup pays interest throughout the life of the loan notes. This article will explain the difference between loan notes and a loan.
What is a Loan?
A loan typically describes any arrangement between a borrower and a lender. The terms of the loan exist in the loan agreement. For smaller borrowing amounts, loans are usually between the borrower (your startup) and a lender, usually a bank. However, specific “private credit” investors may also provide loans to startups.
Loans take a variety of forms. Below are three common examples:
| Type of Loan | Explanation |
| Bilateral Term Loan | YouCo Ltd borrows £500,000 under a bilateral term loan from BankCo plc. YouCo pays 6% interest on the loan twice a year to BankCo, which is two payments of £15,000. The “term” of the loan is for five years. At the end of the period, YouCo must either pay back the entire amount at once or refinance the loan with BankCo or another lender. More complex term loans may have different “tranches” with different interest rates. For instance, YouCo might enter into a term loan with BankCo for £10m. It can “draw down” the loan under three tranches, each with its interest rates. For example, tranche 1 would apply a 4% interest rate to a loan amount upwards of £2m, whereas tranche 2 would apply a 6% interest rate to a loan amount between £2m-£5m. |
| Revolving Credit Facility | A revolving credit facility (RCF) allows startups to draw down and repay funds within the credit limit. Interest is charged on the outstanding balance, and minimum payments are required each billing cycle. RCFs have a revolving nature, replenishing available credit as funds are repaid. |
| Overdraft Agreement | YouCo can borrow against its current account up to a predetermined limit. It usually pays a high-interest rate calculated daily. This makes it suitable for short-term borrowing. Overdrafts can help startups manage their cash flow. |
What Are Secured Loans?
Most but not all loans are secured forms of lending. This means the lender takes security over the borrower’s assets, usually through fixed and floating charges. Fixed charges are attached to the business’s permanent assets, like:
- property;
- machinery; and
- intellectual property.
On the other hand, floating charges attach to current assets like:
- bank accounts;
- trade receivables; and
- inventory.
The nature of floating charges usually allows borrowers to deal with these assets, which they would not be able to under a fixed charge. For instance, a floating charge allows the borrower to sell its inventory. However, a fixed charge prevents this.
What Are Loan Notes?
Loan notes operate differently from loans but are a form of debt financing. A simple loan note transaction might look like this:
- YouCo approaches a lead investor, GrowCo LLP, looking to secure growth financing. YouCo needs £5m of financing. GrowCo LLP is prepared to invest £2.5m of financing in YouCo and will help YouCo source the remaining £2.5m from GrowthCo’s investor network.
- GrowCo finds five other investors, each prepared to invest £500,000 in YouCo.
- YouCo issues each investor one loan note for every £5,000 invested in YouCo. This means GrowCo gets 500 loan notes, and every other investor gets 100 loan notes.
- Each loan note entitles the investors to a pro-rata interest share under the loan note issuance. This is:
| Total Interest Owed under Loan Note Programme (per annum) | £250,000 (£5m x 5%) |
| GrowCo | £125,000 (£2.5m x 5%) |
| Each of the other five investors | £25,000 (£500,000 x 5%) |
- The loan notes mature in five years. This means YouCo must pay each investor back the entire £5m according to their share of loan notes.
- The noteholders are free to sell their notes to one another or third parties during the life of the loan note programme.
What Are Convertible Loan Notes?
In the context of startup financing, it is common for loan notes to have a convertible option. This entitles the loan noteholder to convert some or all of the loan amount to ordinary shares in the startup. This benefits the startup because if the price at which the loans convert is competitive and noteholders exercise their conversion rights, the loan amount balance is written off. This means the startup does not have to repay this amount in cash.
Investors like convertible options because they can participate in successful startup profits. At the same time, if the startup does not meet its growth targets, investors maintain the protections the law affords creditors by not converting the loan notes.
Convertible loan notes typically offer investors lower interest rates than non-convertible notes. This is because investors benefit from the future opportunity to become company shareholders.
What is the Difference Between Secured vs Unsecured Loan Notes?
Some loan notes may be secured. This may be fixed and floating charge. However, if a startup has an existing secured loan, it rarely makes sense to issue secured loan notes on top of the existing debt. This is because the loan will be secured against the startup’s assets.
The benefit of secured loan notes is that they usually offer a lower interest rate than top unsecured notes. This reflects that secured noteholders are in a better position if the startup cannot repay the loan.
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Key Takeaways
Loans and loan notes are both forms of debt financing. For startups, loans are typically borrowing arrangements between a startup and a single bank lender. In contrast, loan notes function like shares issued to multiple investors but are structured like any debt arrangement, with interest payments throughout its life.
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