The fundraising environment is becoming more difficult. Companies looking to raise money, particularly bridge funding are facing more challenging asks from investors. As a result, some investors are now asking companies to provide collateral when issuing convertible loan notes. Our Corporate team considers the key issues with secured convertible loan notes.
The fundraising environment is becoming more difficult.
Businesses looking to raise money are facing more challenging asks from investors. Businesses which need bridge funding can face some particular difficulties, as some investors are now asking companies to provide collateral to secure the investment.
What is a Convertible Loan Note?
Convertible Loan Notes (CLN) are a common way for companies to raise money, particularly for:
- Companies raising seed stage investment
- Companies looking to raise “bridge” funding in advance of a larger equity investment round
In our experience, the current market practice for early stage technology companies raising money with a CLN is to issue the CLN as an unsecured obligation of the company. However, for companies which must now provide collateral to secure an investment, the CLN offers a way of giving this to investors by using a secured CLN.
Secured or Unsecured CLN?
An unsecured CLN provides investors with no special rights or preferences in an insolvency scenario. The obligation of the company to repay the noteholders’ investment ranks equally with the obligation of the company to repay its other unsecured creditors. In practice, this right to repayment could have limited economic value where the business has failed.
A secured CLN can provide an investor with an improved level of protection. A CLN which is secured by a charge over the company’s key assets, e.g. their intellectual property, can materially reduce the economic risk for the investor.
Repayment can be a powerful threat
In practice, a CLN is almost invariably issued by a company with the intention of converting the investment into shares in the company at a later date. The conversion is done on the basis of conversion terms in the CLN, which can include a capped or discounted company valuations.
But conversion into equity is not inevitable.
Companies should remember that the CLN is a debt instrument and the investment is a debt which is repayable by the company. A CLN, whether secured or unsecured, commonly sets out a range of events of default which trigger repayment of the debt.
For the holder of an unsecured CLN, even when an event of default occurs, enforcing the debt is not always an economically attractive option, as the CLN does not rank ahead of the other unsecured debts of the company.
The holder of a secured CLN is in a more powerful position when an event of default occurs. The CLN might allow the investor to appoint a receiver to sell the secured assets and/or to make more credible threats about taking enforcement action.
For the company, providing security creates commercial risk as the holder of the secured CLN may have the power to effectively sell the key elements of the business to a third party. As such, an event of default in the secured CLN can become an existential threat to the continuing operation of company.
More difficult to raise further funding?
Once a company has issued a secured CLN, the company may find it more difficult to raise additional investment in the future.
As a practical matter, the existence of a charge in favour of certain investors will make the company less attractive for any new investors. Even if the secured CLN or related documents does not give the noteholder a direct veto on additional fundraising, the company would need the agreement of those noteholders to create any equal or superior charges in a later investment round.
Investors should be aware that it is not sufficient for a company to simply issue a secured CLN which states that security over specific assets is given to the investor. Any charge, other than a charge over shares or bank accounts, created by a secured CLN must be registered with the Companies Registration Office (CRO) with a prescribed time limit. A registerable charge is which not filed the CRO within the relevant time limit is void as against any liquidator or creditor of a company.
For more details on the registration procedure, see our commentary on the Companies Acts 2014 – Registration of Charges and Priority
If the secured CLN includes a fixed charge over the book debts of the company, then the investor should also make a notification to the Revenue Commissioners under Section 1001 of the Taxes Consolidation Act 1997 to limit its potential liability for certain overdue tax liabilities of the company that granted the charge.
Offering security to investors can be a powerful tool to help companies to secure much-needed investment. Security can provide investors with a material degree of additional comfort to de-risk their investment decision.
However, companies must be aware of the drawbacks of secured CLNs including:
- Potentially greater difficulty in raising subsequent investment, and
- Increased commercial risk to the business, as the core assets of the business are vulnerable if there is an event of default under the CLN
Where secured CLNs are used, the strict registration time limits must be observed.
The content of this article is provided for information purposes only and does not constitute legal or other advice.