What is a Convertible Loan Note?

What is a Convertible Loan Note?

Companies listed on the stock market tend to access financing through one of two routes; raising debt or issuing equity through placings, right issues and other methods. One method of raising funds is essentially a combination of these two, and this method is known as the Convertible Loan Note (CLN) [sometimes referred to as a convertible bond]. This tutorial will look at the general structure of a CLN, at the reasons why a company would opt to issue a CLN over other methods of raising funds and a relevant example of a convertible loan note.

What is a Convertible Loan Note?

A Convertible Loan Note (CLN) is a type of debt instrument that can be converted into equity. It takes the following form: An external investor loans a company £Xm for Z years at an interest rate of B% per year with a Z year loan life.

Putting numbers into that, let's say that an investor loans a company £2m at an interest rate of 5% per year with a 5 year loan life. The conversion price to equity is, say, 100p/share. The investor can either:
1. Opt to keep the debt instrument as debt and have it repaid at the end of 5 years plus interest.
2. Convert the outstanding amount of debt into shares in the company at the pre-determined price of 100p. If the investor chooses to convert the debt into equity, then there is not a debt liability to the company any more.

Or, diagrammatically:

CLN note loan convertible. What is a convertible loan note

A CLN has one main advantage. In the short-run, it provides the company with a non-dilutive form of finance, yet if the company fails to achieve its ambitions and is unable to pay back the debt, then the debt can be converted to equity and the balance sheet is improved. Do note that a convertible loan may have other conditions attached to it such as it only being convertible if a certain amount of profits are reached.

However, the choice to convert to equity often rests solely in the investor's hands so if there is not a strong relationship between the company and the investor, or if the conversion price is not attractive, then it can turn into a more serious problem. For example, if the conversion price is 100p but the share price has dropped to 80p, then the investor would likely not convert to equity and demand cash repayment. That said, it's not always the case and in better circumstances it is the company's choice as to whether it is converted to equity or repaid in cash as a debt instrument.

Example: Tiziana Life Sciences (LSE:TILS)

To make the structure of a typical CLN deal more concrete, let's look at a real life example and pick out the key information.

- Amount raised:   £6.14m
- Number of CLNs issued:   8,780,905
- Loan life:   No specific life. Convertible at any time after 25th June 2016
Party with convertible power:   TILS chooses whether to convert to shares, not the noteholders
- Conversion price to equity:   70p
- Interest rate:   4% per year paid quarterly (every 3 months)

Additional information
- TILS have issued the noteholders warrants. These warrants give the noteholders the option to buy 1,756,185 shares in TILS at 105p per share at any period of time between 26 June 2016 and 31 December 2017. Think of it as a reward for funding the company. As long as the share price is comfortably above 105p, then it is easy profit for the noteholders if they exercise their warrants and sell them in the market.

If the noteholders exercise their warrants, then the company would receive (1,756,185 * 105p) = £1.84m at some point in that date bracket, before costs. Generally speaking, issuing warrants is additional dilution and excessive warrant grants should be viewed negatively. This warrant grant looks a generous, but not overly excessive.

1 comment: