There are many ways in which an organisation can fund its operations: tapping shareholders for equity capital; approaching a bank for conventional debt financing, such as a secured term loan; or using a peer-to-peer crowdfunding platform to obtain the finance needed. There is also another lesser-known option: convertible loan notes.
This article will explain convertible loan notes; the pros and cons of using this form of debt finance; and also examine the use of this debt arrangement in an AIM listed company, to better explain the concept.
What are convertible loan notes?
A convertible loan note (CLN) is a form of short-term debt arrangement which can be converted into equity shares, subject to certain conditions being met in respect of timing of repayment and share conversion price.
These conditions are agreed at the outset and can be quite complex as will be explained below using the Challenger Energy Group Plc (previously known as Bahamas Petroleum) CLN facility as an example.
The price at which the outstanding debt is converted into shares can either be fixed at the time the convertible loan agreement is entered into or it can be linked in some way, to the prevailing share price of the borrower at the time the loan is converted.
Advantages of convertible loan notes
A convertible loan does not have to be drawn down in full once it is agreed. It can be taken at scheduled intervals, the timing can be moved around and, in some cases, the full quantum of the loan agreed does not have to be taken.
Convertible loans can be secured against assets of the borrower, or they can be unsecured. They can attract an interest coupon, which is payable annually or interest can be rolled-up and paid on redemption or conversion. Some convertible loans may even be interest-free.
Unlike more conventional loans, arrangement fees, commitment fees and drawdown fees can be paid by issuing shares instead of paying in cash which help preserve borrowers’ cash resources.
Convertible loan notes have a lot to recommend them: the degree of flexibility around timing of drawdowns; amounts required; fees and interest payable; security needed etc means that convertible loans are a very popular form of debt financing.
The downside of convertible loan notes
It should also be acknowledged that convertible loan notes do bring risks and concerns for both the company (borrower) and its shareholders.
The risk to existing shareholders is that the convertible loan notes are converted into equity at a time when the prevailing share price of the company is at a historical low point. This will lead to many more shares being issued than would have been the case had the loan been converted at a more favourable time. Consequently, convertible loan note holders end up owning more of the company at the expense of existing shareholders.
The concerns for the company centre around the potential complexity and conditions attached to the convertible loan note facility. For example, agreeing an equity conversion price and the timing of the conversion that satisfies both parties, can be challenging; deciding what level of security needs to be offered; managing the expectations of other debt providers and existing shareholders can prove difficult as they will get pushed down the queue when it comes to repayment.
This form of debt financing is also considered high-risk and therefore can be expensive with high coupon rates attached, which impacts profitability.
Bahamas Petroleum Company Plc**
On 21st August 2019, Bahamas Petroleum, (“BPC”) an AIM listed, oil and gas exploration company, with operations in the Bahamas, entered into a secured, £10.5 million (US$12.5 million) convertible loan note facility, to finance the drilling of an initial exploration well.
The facility was agreed for a three-year term, with a coupon rate of 12% per annum, payable annually. BPC also has the option of accruing and capitalising the interest payable i.e. rolling-up the interest and adding it to the loan principal amount. A 3% arrangement fee was payable.
The loan notes also rank ahead of ordinary shares and other debt arrangements so would be repaid first on any return of capital (for example, by way of the sale of BPC or insolvency).
BPC also entered into a Convertible Note Subscription Agreement with the lender (also referred to as subscribers or investors) which gave the subscribers the option to convert the loan notes into ordinary shares, at any time before the maturity date, at a conversion price of 2.5 pence per share.
There were a number of other conditions attached to the Agreement. For example, subscribers have an early redemption option at 110% premium to the face value of the loan notes and no dividends to be declared while the loan notes remain outstanding.
Before any loan is drawdown, whether in the form of convertible loan notes or some other debt arrangement, the borrower must satisfy what are known as ‘conditions precedent’ before the funds will be released.
These conditions precedent are imposed by the lender and often quite standard. They include in BPC’s case for example:
- receipt of any drilling permits and approvals required by law;
- signed contracts for carrying out the drilling operation and the supply of drilling rigs (both from reputable international companies);
- placement of an insurance policy for drilling operations;
- evidence that there will be sufficient cash resources to fund the estimated cost of drilling;
- loan security documentation signed-off etc.
Failure to satisfy these conditions means that the funds may not be released to finance the initial well drilling (although the subscribers could waive some of the conditions attached – for a fee perhaps).
In the event that the loan notes (principal plus accrued interest) are fully drawn down (or subscribed for); and then converted into ordinary shares, this would mean BPC issuing a further 560 million new ordinary shares at the prevailing share price. This will inevitably dilute the holdings of existing shareholders.
In addition, the subscribers would also have an option of subscribing for a further 25 million shares at 2 pence per share, 12.5 million shares at 2.5 pence per share and another 12.5 million at 3 pence per share.
Once BPC has received the funds under the convertible loan note agreement, the subscribers also have the right to appoint up to two directors to the board of the company.
So, as you can see, any company taking on convertible loan notes as a source of finance is conceding a degree of operational control as well as potentially giving up a significant slice of ownership. However, without this finance, investors have to ask, would the company survive; so it may be a price worth paying.
**Bahamas Petroleum Company changed its name to Challenger Energy Group Plc on 17th May 2021
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