Convertible Loan Notes

Convertible Loan Notes or CLNs are loans that have a right to convert into equity at a fixed price after a pre-agreed time. When a loan, they pay interest, and are secured against a company’s assets. Generally, CLNs are event driven in that they are used to support a step change in a company’s growth such as a major contract win or acquisition.

Advantages For Investors

As well as understanding how CLNs can be a better investment method for a company’s management team and existing shareholders, investors also recognise other benefits:

  • Guaranteed income: through payment of interest on a quarterly basis.
  • Equity-like upside: at a price that reflects the forward-looking potential of the company.
  • Security: the CLN has senior security (outside of bank debt). This is normally over the physical assets of the company as well as its trading cash flows. Before investment, an analysis of the available security is undertaken to ensure coverage in a range of scenarios.
  • Contractual liquidity: if the CLN remains as a loan then it has a fixed duration and so there is a defined exit date for the investor.
  • Minimised downside: by remaining as a secured loan, the investor can limit their downside through the senior security.
  • No exposure to market volatility: as a loan, the value of the CLN is not subject to the ups and downs of a company’s share price.

Over the past few years, Welbeck has helped develop an investment structure that major institutional investors are now comfortable with and happy to participate in.

Instead of a right of conversion, some CLNs can be structured as loans with warrants to achieve the same effect.

Comparison to equity and traditional debt

The main differences between the three funding approaches can be summarised as:

  EQUITY DEBT CLN
Guaranteed income
Income (coupon/dividend) 0 - 4% 4 - 8% 8 - 12%
Equity-like upside
Security over assets
Senior ranking
Contractual liquidity for exit
Access to private information
Equity downside risk
Exposure to market volatility
SEE HERE
  EQUITY DEBT CLN
Guaranteed income
Income (coupon/dividend) 0 - 4% 4 - 8% 8 - 12%
Equity-like upside
Security over assets
Senior ranking
Contractual liquidity for exit
Access to private information
Equity downside risk
Exposure to market volatility

An example of a transaction

To illustrate the financial benefits of a CLN we have compared the effects of an equity raising to a CLN when undertaking a fund raising equivalent to 10% of a company’s market capitalisation:

BASIC ASSUMPTIONS
 
Shares outstanding 19,080,000
Current share price £1.9335
Market capitalisation £36,891,180
Funds raised £3,700,000
 
ON AN EQUITY FUND RAISING
 
Discount for equity fund raising 10%
Equity fund raising share price £1.7401
No of shares issued 2,126,314
 
ON A CLN FUND RAISING
 
Premium to share price for convertible loan 25%
Loan conversion price £2.4168
No of shares loan converts into 1,530,950
 
DIFFERENCES THROUGH USING A CLN
 
Reduction in number of shares issued 595,364
One off saving from issuing fewer shares £1,439,000
Annual interest payable of 10% on CLN -£370,000
Annual tax credit on coupon of CLN £74,000
 
SAVINGS TO ALL SHAREHOLDERS WHEN THE CLN CONVERTS
 
If the CLN converted after 1 year £1,143,000
If the CLN converted after 2 years £847,000
If the CLN converted after 3 years £551,000
 
SEE HERE
BASIC ASSUMPTIONS
 
Shares outstanding 19,080,000
Current share price £1.9335
Market capitalisation £36,891,180
Funds raised £3,700,000
 
ON AN EQUITY FUND RAISING
 
Discount for equity fund raising 10%
Equity fund raising share price £1.7401
No of shares issued 2,126,314
 
ON A CLN FUND RAISING
 
Premium to share price for convertible loan 25%
Loan conversion price £2.4168
No of shares loan converts into 1,530,950
 
DIFFERENCES THROUGH USING A CLN
 
Reduction in number of shares issued 595,364
One off saving from issuing fewer shares £1,439,000
Annual interest payable of 10% on CLN -£370,000
Annual tax credit on coupon of CLN £74,000
 
SAVINGS TO ALL SHAREHOLDERS WHEN THE CLN CONVERTS
 
If the CLN converted after 1 year £1,143,000
If the CLN converted after 2 years £847,000
If the CLN converted after 3 years £551,000
 

As shown the company receives less dilution in exchange for paying an attractive coupon to the investor, whilst making significant savings on the cost of the fund raising over 1, 2 or 3 years.

Advantages For Companies

Normally between £1M to £10M the CLN offers many advantages to companies including:

  • Less dilution for existing investors: The conversion price is set at a premium to the placing or share price of the company at the time of completion. This means there is less dilution when the CLN converts into fewer shares.
  • Cheaper funding and on conversion the loan goes away.
  • Certainty of funds: The CLN funding can be agreed in advance of a major event such as a contract win or acquisition, thereby giving certainty of pricing and delivery.
  • Working with experienced investors: Welbeck works with the main institutional investors and investment groups on the AIM market.
  • Inherently more equitable to all of a company’s shareholders, many of whom are often not invited to participate in price discounted equity placements which are normally only offered to substantial shareholders.

A CLN financing benefits all of a company’s shareholders by reducing dilution through allowing new investors to participate at a premium to the current equity valuation.

As well as funding public companies, CLNs can be used to fund private companies that are preparing for an IPO, helping them to achieve the all-important working capital sign-off.