What it means
In substance a loan note is simply debt, but the legal form matters. Because the terms are captured in a transferable instrument, the holder can often sell the note to another investor, which is far harder with an ordinary bilateral bank loan.
Companies use loan notes when a bank facility is unavailable, too slow or too restrictive. They appear in management buyouts, in acquisitions where part of the price is deferred, and in fundraising from private investors who want a fixed return rather than shares.
The typical structure pays interest periodically and repays the whole principal as a single bullet at maturity. Notes may be secured against assets or unsecured, ranked ahead of or behind other debt, and sometimes convertible into shares if the holder chooses.
Loan notes issued as part of a purchase price are common in company sales. Instead of paying everything on completion, the buyer issues notes to the seller for part of the consideration, which spreads the buyer's cash outflow and keeps the seller interested in a smooth handover.
The nuance to check is ranking and security. Two notes paying identical interest can carry very different risk depending on whether they sit ahead of the bank in a wind-up, so subordinated unsecured notes should always price higher than secured ones.
In practice
Real-world examples.
Example
A private investor lends $250,000 to a growing logistics firm through a two-year secured loan note at 9%, taking a charge over the company's vehicles. The fixed return and defined repayment date suit the investor better than taking a minority shareholding.
Example
In a management buyout, the outgoing owner accepts $2,000,000 in cash and $1,000,000 in loan notes repayable over three years. This lets the buyers complete without raising the full amount up front.
Example
A property developer issues unsecured loan notes to around 40 investors to fund a site purchase, offering 8% interest and repayment on completion of the scheme. Because the notes rank behind the senior bank debt, the rate is well above bank pricing.
Formula
Calculation
Annual interest = Principal x Coupon rate, and total repayment = Principal + total interest over the term. A company issues a $500,000 loan note with a 7% annual coupon and a 4-year bullet maturity. Interest each year is $500,000 x 0.07 = $35,000, so over four years the interest totals $35,000 x 4 = $140,000. At maturity the company pays the final year's interest plus the principal, that is $35,000 + $500,000 = $535,000. Total cash paid across the life of the note is $500,000 + $140,000 = $640,000. If the note had been issued at 98 cents on the dollar, proceeds would be $500,000 x 0.98 = $490,000, raising the effective cost because $500,000 is still repayable.Case study
Seen in the real world.
Ellerby Foods is a fictional business used here for illustrative purposes. Its founder agreed to sell the company for $3,500,000, but the management buyer team could raise only $3,000,000 between bank debt and their own equity.
To bridge the gap, the illustrative deal included a $500,000 loan note issued to the founder, carrying a 7% coupon over four years with a bullet repayment. That gave the founder $35,000 a year in interest and $535,000 at maturity, and gave the buyers a $500,000 smaller cash requirement on completion.
The note was subordinated to the bank facility and contained a clause suspending interest if a bank covenant was breached. When trading dipped in year two, that clause did exactly its job: interest was deferred for two quarters, the bank stayed comfortable, and the note was repaid in full at the end of year four.
Watch out
Common mistakes.
- Treating a loan note as equity because it was issued in a deal, when it is debt that must be repaid whether or not the business performs.
- Comparing two notes on coupon alone without checking security and ranking, which are what really determine the risk being taken.
- Forgetting that a bullet repayment means a large sum falls due on a single day, which needs planning years in advance.
Questions
People also ask.
Is a loan note the same as a bond?
They are close relatives, but bonds are typically larger, listed and traded on a market, while loan notes are usually private and held by a small number of investors.
Can a loan note be sold to someone else?
Usually yes, subject to the transfer conditions written into the instrument, which is one of the main advantages over an ordinary loan.
What does subordinated mean on a loan note?
It means the holder is paid only after senior lenders have been repaid in full if the company fails, so the note carries more risk and a higher rate.
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