Convertible loan notes gone wrong

A hair and beauty start up came to us with an investor ‘starter pack’ which included a convertible loan note agreement, new articles and a shareholders’ agreement drafted by an investment company. We were asked to review and comment but the documents had already been signed. Our client was horrified at teh control and legal rights the investors had in practice.

The problem was the agreements were between two businesses and it was likely any court would have expected the directors to have been aware of their commitment before signing and so would not easily accept any argument that the borrowers were ignorant or somehow duped. The only way out was to negotiate a settlement and find ways of making it attractive for the investment company to agree to early repayment of the convertible loan to released the business from the stranglehold the investors had over it.

Very high interest and conversion rate

We found that buried in the small print for the loan note was a conversion rate of 175% of the loan amount, the redemption rate was also 150% of the loan amount. The interest rate was 8% per annum. If there was a conversion or redemption this annual interest amount was due, irrespective of whether the conversion or redemption occurred on January 1 or December 31.

Other rights the lender included in the Loan Note Agreement

The investment company had also included  clauses in the loan note agreements given itself  discretionary conversion and redemption rights in a wide variety of situations including :-

• any kind of actual or anticipated insolvency event
• issuance of any shares
• change of control
• breach of any documents in the investment pack including the shareholders agreement or articles of association.

The Company had no right to terminate, convert or redeem the convertible loan note.

Lender control via Shareholders Agreement/Articles of Association

The investor/lender had inserted a number of rights at shareholder level including :-

•  entrenched directorship rights, which meant their nominated directors could not be removed without the investment company’s consent
• weighted voting so that the investment company had the final say on any decisions of the board of directors (and practically, the day to day running and management of the business).
• the business was effectively prohibited from hiring staff, buying equipment and even paying bills without the investor’s consent.
• Compulsory transfers of shares were imposed on the founders shares which effectively locked them in for two years. Following the lock period in the founders were subject to such wide ‘bad leaver’ provisions for practical purposes almost all circumstances of leaving meant a sacrifice of their entire shareholding for pennies.
• Full pre-emption rights restricted issuance of new shares and transfer of founder shares.

Restrictive Covenants on founder shareholders

Restrictive covenants were imposed against the founders for two years after they ceased to be shareholders. The restrictions included full non-competes, non-solicitations and non-dealings, essentially restricting them out of the UK hair and beauty market.

No such restrictions were applicable to the investment company who could invest freely into competitive businesses.

Net result - the lenders had the ability to manipulate the loan notes

As a result of everything described above, the Company was  effectively trapped in a spiders’ web.  If the Company needed further investment it was completely beholden to the lenders who ckould prevent further borrowing. The investment company could ‘pull the plug’ on the initial funds at any point as it was fairly easy to “manufacture” a breach of the documents which were so blatantly pro-investor. There was no chance of attracting new investors with such a cumbersome and expensive cloud hanging over the business.

We helped the Company negotiate a way out. We were able to get the total repayment cost discounted by half with staged repayments, over the course of 18 months to allow the Company to financially recuperate.

If you are presented with a “starter pack” setting out documents for investment please do come and speak to us. We have the experience of acting for founders, businesses and investors and know our way around the documents. The costs of review make economic sense when compared with the risks of not knowing what you are signing up to. Please call us on 0207 438 1060.