Alex is Sprintlaw’s co-founder and principal lawyer. Alex previously worked at a top-tier firm as a lawyer specialising in technology and media contracts, and founded a digital agency which he sold in 2015.
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When you’re growing a business or startup in the UK, funding is often front of mind. There are plenty of ways to get the capital you need to kick things off or take your venture to the next level. But when it comes to borrowing - whether from banks, private investors, or even friends and family - understanding your options is absolutely crucial for safeguarding your business’s future.
Two terms that frequently get tossed around are “loan” and “loan note”. While they sound similar, these are actually quite different mechanisms - and each can play a unique role in your funding journey. Whether you’re raising a major round for your startup or simply weighing up debt versus selling shares, it’s vital to decode these choices so you know exactly how you’re financing your growth (and what you’re committing to).
In this guide, we’ll break down - in plain English - what a loan is, what a loan note is, how each works, and when you might use one over the other. We’ll also walk through a real-world example and share practical tips for making a legally sound choice for your business.
What Is a Loan?
Let’s start at the very beginning: what is a loan, exactly?
In simple terms, a loan refers to an agreement where one party (the lender) provides money to another party (the borrower), who agrees to pay it back - usually with interest - within a specific timeframe. Loans are among the oldest and most straightforward forms of business finance. Here’s what typically characterises a standard business loan:
- One-to-one arrangement: Traditional loans usually occur between a business and a single lender, such as a bank, alternative lender, or an individual.
- Formal legal agreement: The terms of the repayment, interest rate, schedule, and consequences for missed payments are recorded in a detailed loan agreement (or sometimes a facility agreement for bigger sums).
- Interest and repayment: You’ll pay interest at an agreed rate, either as monthly, quarterly, or annual instalments. Repayment of the principal can be by instalments or as a lump sum at the end (known as a “bullet repayment”).
- Rarely transferable: Loans are usually "private" between the two parties. You can’t just transfer your obligation to another lender without lots of paperwork.
- Potential security: The lender may ask for security over assets, such as a charge over your company’s stock or equipment, to protect themselves if you default.
In other words: a loan is a direct promise to pay back the money you’ve borrowed, with clear expectations on how and when the lender gets their money back - and what happens if you don’t.
Defining "Loan Note": What’s Different?
Now, let’s decode the next term: loan note. What is a loan note, and how does it work?
A loan note is a formal debt instrument - a legal document issued by a company in exchange for money provided by an investor or group of investors. But unlike a simple loan, loan notes are designed to be offered to multiple investors, each receiving a “note” confirming how much they’re owed, rather than the company negotiating separate individual loan agreements with each person.
The key features of a loan note include:
- Issued in “units” or “notes”: Rather than borrowing a lump sum from one lender, the business offers a number of loan notes (each representing a fixed investment amount) which different investors can subscribe to.
- Pro rata obligations: Each noteholder is owed interest and repayment in proportion to their note-holding. Interest is distributed accordingly across all investors.
- Tradable: Unlike a typical loan, loan notes may be transferable - meaning investors can sell their note to someone else, giving them more liquidity. This makes loan notes closer to a share instrument, while still being classed as debt.
- Fixed term and interest: The notes set a specific interest rate and term (for example, 5 years at 7% interest). At the end of the term (“maturity”), the investment principal is returned, unless the notes convert (in the case of convertible notes - a separate topic).
Loan notes are commonly seen in startup and scale-up funding rounds, especially where you want to tap into a pool of high-net-worth individuals, business angels, or even existing shareholders for debt finance. They’re a flexible way to raise funds without taking on new share investors or negotiating with a single lender.
Loan vs Loan Note: Key Differences Explained
With both options acting as forms of “debt” - why does it matter whether you use a loan or a loan note? Here’s a side-by-side look at some of their main differences:
| Feature | Standard Loan | Loan Note |
|---|---|---|
| Lender Structure | Usually one lender (e.g. a bank) | Multiple investors subscribe, each receives a note |
| Agreement Type | Single contract | Multiple notes + master note instrument |
| Interest Payment | Paid to one lender | Distributed pro rata to all noteholders |
| Repayment | Lump sum or instalments | Lump sum to all noteholders on maturity |
| Tradability | Rarely transferrable | Often transferable (can be sold) |
| Flexibility | Fixed terms, limited negotiation | More customisable; used for complex fundraising |
| Admin Burden | Simple for small sums | More paperwork, but easier for group funding |
This comparison shows that while both a loan and a loan note result in your business owing money, the process, flexibility, and use case for each differ quite a bit. Read more on promissory notes vs loans if you want to compare other debt options.
Example: How Do Loan Notes Work in Practice?
Let’s imagine your startup, "YouCo", is ready to expand nationally and needs to raise £5 million to do so. Here’s how the two funding options could play out:
Option 1: A Traditional Loan
- You approach a high-street bank.
- The bank assesses your financials and agrees to lend £5 million at 4% interest, to be repaid in quarterly instalments over five years.
- You sign a single loan agreement. Repayment (including interest) goes to the bank alone.
- The loan is not easily transferrable to another lender unless you renegotiate.
Option 2: Loan Notes
- You appoint a lead investor who agrees to fund £2.5 million, but wants to share the risk and opportunity by recruiting four other investors to come in for £625,000 each.
- You issue 1,000 loan notes, each worth £5,000 (total £5 million).
- Loan notes are distributed pro rata among investors based on their chosen investment amount:
| Investor | Investment | Loan Notes Held | % of Total Notes |
|---|---|---|---|
| Lead Investor | £2,500,000 | 500 | 50% |
| Investor A | £625,000 | 125 | 12.5% |
| Investor B | £625,000 | 125 | 12.5% |
| Investor C | £625,000 | 125 | 12.5% |
| Investor D | £625,000 | 125 | 12.5% |
- Each year (with interest set at, say, 5%), the company pays out £250,000 in interest, distributed pro-rata to owners of the loan notes.
- After five years, the company must repay the full principal (£5 million), usually by paying each investor their original invested amount.
- If Investor D wants to sell out after 2 years, they can transfer their 125 loan notes to a new investor, giving the business ongoing access to capital and providing liquidity for departing investors.
This setup gives your business flexibility in raising larger sums, tapping a pool of backers - while offering those backers some of the transferability and “tradable” aspect they’d expect from owning shares (but without giving away equity).
For a more detailed breakdown and example of loan notes in a funding round, check out our guide: A Guide To SAFE Notes.
How Is Interest Paid and Repaid in Loans vs Loan Notes?
One of the biggest questions surrounding both loans and loan notes is how - and when - investors get their returns.
Loans
- Interest is typically paid on a regular schedule (monthly, quarterly, or annually) to the lender, at a rate agreed in the contract.
- The interest and principal repayments are made per the loan agreement. Missing a payment can trigger penalty fees or default clauses.
Loan Notes
- Interest is distributed pro-rata among all holders of the loan notes, based on their share of the overall investment.
- Interest payments may be made annually or “rolled up” and paid with the returned principal at the end (depending on the agreement).
- On maturity, each noteholder is paid back the exact sum they invested - unless the agreement allows for conversion into shares or another arrangement.
- For startups considering convertible loan notes, learn more about how convertible notes work in the UK here.
Are Loan Notes Transferable or More Liquid?
This is a key advantage of loan notes: tradability. With a standard loan, neither the lender nor borrower can simply “transfer” the agreement without going through a lot of legal red tape. In contrast, loan notes are often specifically structured so that they can be sold to a third party.
What does this mean in practice?
- Loan notes can be bought and sold - sometimes through private negotiation and sometimes through specific sales provisions in the loan note instrument.
- This gives greater flexibility to investors, who might want to exit early or realise their return ahead of the maturity date.
- However, some instruments may have restrictions: always check transfer conditions and get legal advice before proceeding with any transfer.
If your fundraising plan includes allowing early exits for investors, loan notes are a strong choice. Just be aware that any transfer must comply with all relevant business regulations, and the legal documents should be carefully drafted.
When Should You Use a Loan Note Over a Traditional Loan?
Deciding which debt tool to use depends on your business’s size, fundraising needs, and flexibility.
- Traditional loans are usually best for smaller, straightforward borrowings, or where you have an established track record (banks tend to dislike complexity or pooling multiple backers).
- Loan notes are particularly handy for larger or more complex rounds involving multiple investors. They’re also a good way to let your backers participate in your business’s growth without giving up equity.
Loan notes and their close cousin, convertible loan notes, are often preferred in the following scenarios:
- You want to offer flexible investment options to angel investors, VCs, or even employees (via a scheme).
- You need a funding product that’s attractive because it’s transferable or can convert to equity later (e.g., ahead of a share issue or listing).
- Your investors want an instrument that looks and feels more like a bond while remaining private, secured, or semi-private (outside of public markets).
Not sure which way to go? Our startup legal team can advise you on your funding options.
Common Risks and Legal Must-Knows
It’s easy to see why loan notes can be appealing. But as with any major business decision, you need to be aware of the risks and regulatory requirements. Here’s what to keep on your radar:
- Documentation must be watertight: Don’t try to draft your own loan note instrument or loan agreement - use an experienced contract lawyer to get this right.
- FCA and regulatory compliance: In the UK, selling loan notes to the public (or to unregulated investors) can trigger rules under the Financial Services and Markets Act and FCA rules. You need legal advice to make sure your offer is compliant, particularly for collective investment schemes.
- Security and priority: Investors will want to know if their note is “secured” (with company assets pledged), its rank among other debts, and any potential conversion rights.
- Consumer credit laws: If your product is offered to individuals, consumer credit regulations may apply.
- Commercial risk for both sides: As always, there is default risk - the risk you can’t repay on time. Both lender and borrower should understand what happens if the company gets into trouble.
Getting your legal documents for business funding right from day one can save everyone a world of pain later.
Key Takeaways
- Loans are direct, single-lender, non-tradable forms of debt, usually best for smaller or simpler borrowing arrangements.
- Loan notes enable you to raise debt capital from multiple investors at once, are often tradable, and allow greater flexibility in distribution and repayment.
- Interest in both models is usually fixed, but the means of payment and mechanisms for transfer or early exit differ.
- Loan notes are a standout choice for startups seeking larger or more collaborative fundraising, but they come with more paperwork and regulatory requirements.
- Whichever option you choose, your documents should be professionally drafted to avoid non-compliance, disputes, or unexpected consequences.
- Always get tailored legal advice before committing your business to new debt or investment arrangements.
If you’re planning to raise funds for your startup or want advice on the best funding option for your next round, Sprintlaw can help. Get in touch for a free, no-obligation chat - call us on 08081347754 or email team@sprintlaw.co.uk.
