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Raising cash using convertible loan notes
Profitable small companies can reduce their cash interest payments by issuing convertible loans instead of high-interest bearing debt. The benefit to companies is that the loan holder has the option to convert the debt to ordinary shares (equity) and wipe out the loan (and interest payments).
My definition of a small company for these (corporate finance) purposes is a company with between $500k to $5 million in net operating profit after tax and before interest.
So why don’t more small companies use convertible loan notes? Here’s my view – there are only three reasons:
- The other names (for convertible loan) used by investment bankers such as ‘hybrid securities’ infer a more complex arrangement than is the reality. Consequently, owners of small companies believe the use of convertible loans is only for large companies.
- Finance directors of small companies believe they don’t have enough finance structuring experience to set up a convertible loan note. That’s nonsense and a good lawyer is the finance director’s best friend when it comes to setting up convertible loan notes.
- Due to the above two points, bankers of small companies will not have seen a prolific use of convertible loans. Hence, when saying “no” to their clients, the banker will recommend an equity provider as the alternative. Whereas, a convertible loan note provider (or provider of hybrid securities – to use the ‘big boys’ term) is often a more viable alternative.
Small companies with profits tend to have more consistent valuations than start-ups. Hence, finance directors and the hybrid equity provider (of the convertible loan note) will be able to objectively agree on the conversion price of the debt to equity.
Short message: If you are a small company looking to raise new finance then talk to your lawyer about the use of convertible loan notes.
A word of warning to loss-making start-ups reading this article: Think very carefully about using convertible loan notes as a means to defer a decision on the valuation of your company. The premise that not valuing a company’s financing round today will induce a higher value later is a flawed premise. Professional investors will value the company based on all the current information and will largely ignore so-called ‘reference’ valuations of past inexperienced ‘friends & family’ investors.