The government has announced its £500m Future Fund to help save growth companies that do not benefit from existing coronavirus business support.

From May, the government will offer loans of between £125,000 and £5m to growth companies, either to be repaid by businesses after three years or turned into equity stakes in tech start-ups owned by the state. These are called convertible loan notes.

>See also: Future Fund – government tech start-up bailout scheme how it works

The government money will have to be matched equally by private investors such as venture capitalists.

Nevertheless, the government could end up with stakes in some of the UK’s fastest-growing companies.

The Future Fund convertible loan notes may turn into equity at a discount of at least 20 per cent when companies undergo their next funding round.

What is a convertible loan note?

A convertible loan note is a debt, with a mechanism for the principal amount (plus interest, if any) to convert into equity in certain circumstances. Conversion occurs on a “qualified financing” (set by reference to a perceived valuation) but also will take place on an event of default or on a sale, change of control or liquidation of the business.

The following provisions are commonly included:

• Interest: convertible notes often have no or low interest rates, or where interest does accrue it is rolled up and converted into shares along with the principal amount (hence the term, ‘capitalised interest’)
• Discount on conversion: convertible notes will generally convert at a discounted price per share to that being paid by new investors participating in the “qualified financing”
• Valuation cap: investors may demand a cap on valuation, increasingly in addition to (and not as an alternative to) a discount on conversion. The cap may be set by reference to the pre or post money valuation, with the former leading to the most significant potential reductions in share price. Another approach is to specify that on conversion the convertible loan note holders will be entitled to a fixed percentage shareholding. Assuming the valuation is higher on the qualified financing, this effectively gives a discount to the lenders
• Long-stop/maturity date: “equity-based” convertible loan notes convert automatically to shares at maturity whereas “debt-based” convertible loan notes will need to be redeemed by the company in cash. For automatic conversion to occur, the price per share will need to be prescribed

Pros and cons of convertible loan notes

Advantages

• Negotiating and documenting a straight equity investment can be complex, time-consuming and costly from a legal perspective. Convertible loan note instruments tend to be shorter, simpler documents with fewer commercial terms to agree
• Convertible loan notes can be attractive given their status as debt prior to conversion. This gives the convertible loan note holders priority over shareholders on a liquidation and this type of investment can therefore be viewed as being less risky
• The consent of the convertible loan note holders is needed before the company can take on any other debt, and such debt is commonly required to be subordinated to the loan notes, putting the convertible loan note holders in a more advantageous position than other unsecured creditors

Disadvantages

• The cap on a valuation needs to be negotiated and documented in the same way as on an equity round. Equally, if shares are to be issued automatically on a long stop date then the price per share (or a mechanism for determining it) will need to be fixed. This means that some of the detailed negotiation will need to take place now, detracting from the time and cost savings
• A discount on conversion and/or a cap on valuation can have negative consequences for the company and its existing shareholders:
  – If note investors are entitled to a large discount and their shares will make up a high proportion of the new shares to be issued, this can substantially depress the actual amount of new money that will result from the “qualified financing”.
  – An artificial cap on valuation may drive down the actual valuation on future rounds as new investors will not want to invest at a significantly higher price. The dilution of existing shareholdings may be more extensive. New investors may call for non-founder shareholders to bear the brunt of this in order to preserve founder shareholdings at an appropriate level. It is therefore not unusual to see incoming investors seeking to pressure note investors into renegotiating their terms.
• Conversion of “equity-based” convertible notes at the end of their terms will generally be at low valuations

Timothy Leeson is a partner and head of Lewis Silkin’s corporate finance practice