Loan notes are a common way for businesses to raise money. Companies use them to support growth, bridge funding gaps, or refinance existing debt. Loan notes bring in investment without giving up equity or control. But like any financial tool, they come with risks.
This guide explains the key advantages and disadvantages of loan notes. It will help you decide whether they suit your business goals.
Advantages of loan notes
Raise capital without losing control
Loan notes let businesses raise funds without diluting ownership. This is vital for owners who want to keep decision-making power.
Flexible terms
Loan notes can be tailored to suit both businesses and investors. You can set the interest rate, repayment schedule, and even allow for conversion into equity.
Attractive to investors
Investors often find loan notes appealing. They offer steady income and predictable returns. Secured loan notes, in particular, present lower-risk investment opportunities.
Simpler process
Loan notes involve less complex documentation than issuing equity. This makes them a faster and more straightforward way to raise funds.
Risks and drawbacks of loan notes
Loan notes also carry risks. Both businesses and investors must understand these before proceeding.
1. Credit risk: The risk of default
The biggest risk is that the business may default. If the company can’t repay the loan or meet interest payments, investors could lose money.
Unsecured loan notes are especially risky as they lack collateral. Even secured notes are not risk-free. In liquidation, asset sales may not cover the debt.
2. Interest rate risk: Fixed or variable uncertainty
Loan notes may offer fixed or variable rates. If market interest rates rise, fixed-rate notes can lose value. If the rates are too low, returns may be less attractive.
For variable-rate notes, rising rates can increase costs for the business, while falling rates can reduce returns for investors.
3. Liquidity risk: Difficulty selling early
Loan notes are not as liquid as public shares or bonds. Investors may struggle to sell before maturity, especially in private placements. This can tie up funds longer than expected.
4. Risks of conversion: Convertible loan notes
Convertible loan notes allow debt to be turned into equity. This feature has its own risks:
Valuation risk: If the company’s value is lower than expected, converted shares may be worth less.
Dilution risk: Conversion can reduce existing shareholders’ control.
Financial risk: If the debt isn’t converted, the company still needs to repay it.
Future impact: Generous terms for early investors may deter future investment.
5. Covenant risk: Restrictive conditions
Many loan notes include covenants—rules the business must follow. These may limit taking on more debt, require financial ratios to be maintained, or restrict dividends.
For companies, these can reduce flexibility. For investors, breaches can signal financial trouble.
Should you use loan notes?
Loan notes can be a powerful funding tool. They offer flexibility and control but come with risks that need careful management. Before using loan notes, businesses and investors should seek professional advice to ensure they align with financial goals.