What Are Loan Notes and How Do They Work?

Explore how loan notes work and what the differences are between the variants of them within this article.

Updated: January 2, 2024
Matt Crabtree

Written By

Matt Crabtree

 

If you're running a small company and are exploring a few ways you can finance a possible business venture or even just contemplating some investment opportunities, there's a good chance you've come across the term ‘convertible loan note instrument' or just ‘loan notes'.

In comparison to your more traditional loan, these particular financial instruments might sound a bit complex at first, but they're definitely worth understanding, given how crucial a role they play in the world of business financing.

So, throughout this article, we'll be breaking down some basics of loan notes — looking at the various types, how a loan note works, and what responsibilities loan note holders have.

Understanding Loan Notes

Let's get started with a few of the fundamentals.

The Basics of Loan Notes

Put simply, a loan note is a type of legal agreement that represents a loan made by you, the investor (usually referred to as a loan note holder), to a borrower, which is typically a business.

In essence, it acts as a kind of formal record of the total amount that's been borrowed, including things like the interest rate and the repayment terms you've both agreed upon.

Aside from this, they're helpful for providing some clarity and legal protection for everyone involved, too, so they're quite essential when it comes to facilitating financial transactions.

Types of Loan Notes

Moving forward, let's break down the most common variations of loan notes:

1. Convertible Loan Notes

Unlike some of the more traditional loan notes, these, in particular, have a fairly unique feature — they can convert the outstanding debt into equity.

Naturally, this flexibility can be pretty attractive to both parties involved, since it opens a door for the note holder to potentially become an equity investor in the business.

2. Secured vs. Unsecured Loan Notes

Next, there are secured loan notes, and these are backed by collateral (meaning you have to pledge some of your assets in order to secure the loan). On the other hand, though, their counterparts, unsecured loan notes, don't require any kind of collateral — so they're a bit riskier for the note holders but generally more appealing for borrowers.

Ultimately, you'll have to decide how much risk you're willing to bear before deciding if you'd rather choose an unsecured or secured loan note.

How Loan Notes Work

Let's explore how loan notes work in a little more detail next.

The Loan Agreement

As touched on earlier, a fairly comprehensive loan agreement is drafted out with all the terms and conditions whenever a loan note gets issued, and this includes things like the principal amount, interest rate, maturity date, and any other kinds of specific provisions there might be for conversion rights, for instance.

Interest Payments and Maturity Date

Generally speaking, the aforementioned interest payments tend to be a crucial part of loan notes, as the interest rate represents how much the borrower will need to periodically pay in order to compensate for the risk that the note holder is taking.

As for the maturity date, this is just the deadline for the borrower to repay the principal amount in full.

Convertible Loan Notes in Action

Convertible loan notes are generally a lot more appealing to startup business owners who are looking for financing, given how the potential for equity conversion tends to attract a lot of investors who perhaps aren't traditional equity investors.

So, the idea here is that they'll provide you with the funds, and if your startup ultimately succeeds, the note holders have an opportunity to convert their debt into equity, which would allow them to become shareholders in your company.

Vendor Loan Notes

Vendor loan notes are another term you'll see a lot in business transactions, and these are just loan notes that the seller provides to the buyer — often as a part of the overall purchase price.

It gives the buyer an opportunity to secure financing, and the seller gets a nice stream of income, so this can definitely be a beneficial arrangement for both parties.

Related Guides:

What Are Loan Notes and How Do They Work: FAQs

Which Industries Are Convertible Loan Notes Usually Utilised?

Can Loan Notes Contribute to a Business's Tax Strategy?

Are There Specific Scenarios Where Businesses Prefer Unsecured Loan Notes?

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