Convertible debts are a type of hybrid security instrument that has the same features as normal debts such as interest payments but also comes with the option to be converted into common equity shares of a company.
The option to convert the debt to common equity shares lies with the debt holder or the investor. The conversion is based on a predetermined ratio at certain points in time.
If an investor chooses not to convert the debt, they are repaid their initial investment by the company.
Convertible debts are provided by early investors of a company such as angel investors or venture capitalists.
These are high-net-worth individuals or firms that invest in a company in its early stages with the expectation that these debts can be converted into equity instruments for the company in the future.
Convertible debt instruments provide debt holders with some advantages. They provide the debt holders with extra security as they have the option not to convert their debt into equity if the company’s common equity shares prices are lower than the value of the convertible debt in the stock market.
Furthermore, convertible debt holders will be paid off before their equity stockholders in the case of liquidation of the company.
For companies, particularly startups, convertible debts provide an alternative funding source. Investors generally avoid investing in startups’ equity instruments due to their risks.
Startups can’t raise debt finance, such as loans from banks, easily because they don’t have any credit history and, generally, no security to provide instead of the debt.
Convertible debts allow companies to attract investors because convertible debts reduce the risk of investment for investors.
For companies, convertible debts can also be disadvantageous since the option to convert lies with the debt holder.
When the conversion is favorable for the debt holder, they will choose to convert.
In addition, convertible debts come with the disadvantage of a possible dilution of ownership in the future.
Furthermore, convertible debts also increase the risk of finance for the company as convertible debts are debts and in case of default, the company may face legal actions.
Components of Convertible Debt
Convertible debts have a face value, the principal amount of the instrument mentioned on the convertible note.
In addition, convertible debts also have an interest rate, which is paid out by the issuing company to the debt holder annually until the maturity date is reached.
Some companies also offer a compound interest option for their convertible debt instruments.
Companies usually issue convertible debt instruments until a specific time, known as its maturity date.
Once this maturity date is reached, the face value of the instrument is paid back to the debt holder if they have not already availed of the conversion option.
Companies prefer to offer convertible debt instruments with a later maturity date because it allows them more time to pay back the instrument.
In contrast, investors prefer convertible debt instruments with earlier maturity dates because it decreases their investment risk.
Finally, convertible debt instruments come with conversion terms. These terms describe the convertible ratio of the instrument and the times at which investors can avail the option.
The convertible ratio is the ratio at which the convertible debt will be converted into common equity shares.
For example, for every $100 of the face value of convertible debt, the company may offer 10 common equity shares.
Types of Convertible Debt
There are 3 main types of convertible debts. These are vanilla convertible debts, mandatory convertible debts, and reversible ones.
Vanilla convertible debts are the most common type of convertible debt. These give the debt holder the option to convert the debts into common equity shares at a given convertible rate at the maturity date.
Mandatory convertible debts do not give the debt holder the choice to convert the debts at the maturity date.
Instead, these debts are converted to common equity shares regardless of whether the debt holders want to convert or not.
Therefore, mandatory convertible debts are more advantageous for startups as they don’t have to pay the initial amount of debt back to the debt holder, thus, not resulting in a cash outflow.
Finally, reversible convertible debts are the opposite of vanilla convertible debts. Instead of the debt holder, the company has the option to convert the debt instrument to common equity shares for the debt holder.
Established companies generally offer these types of convertible debts.
Example of Convertible Debt
For example, suppose a company ABC Co. issues a convertible debt instrument with a $1,000 face value and a convertible rate of 20 common equity shares for $1,000 face value with a 5% interest rate.
Furthermore, the convertible debt instrument has a maturity date of 7 years. At this point, the company’s common shares are traded in the stock market for $48.
In the above example, the convertible debt holder can hold their convertible debt until the maturity date is reached without converting them.
At the maturity date, the convertible debt holder will receive $1000 for the principal amount of the instrument.
In addition, the debt holder will also receive interest payments of $50 ($1,000 x 5%) per year and the maturity year.
This means they will receive $1,350 ($1,000 principal and $350 interest) at maturity.
If the company’s common shares at the maturity date are traded in the stock market for $48 without any rise.
If the debt holder converts to common equity shares, they will receive 20 common equity shares of the company.
This means the debt holder will receive $960 for their original investment of $1,000. Debt holders will not convert if this is the case.
However, let’s suppose at the end of the life of the convertible debt, the value of the company’s shares rises to $55 per share.
At this point, if the debt holder converts, they will, again, receive 20 common equity shares for $1,000 in convertible debt instruments.
The common equity shares will have a market value of $1,100 ($55 x 20 shares). The investor can sell these shares in the market to make a profit.
Convertible debts give the debt holder the option to convert the convertible debt instrument to common equity shares of a company at maturity.
This allows startups to generate funds while the debt holders are provided with more security and lower risk than equity instruments.
Convertible debts also have other types that may allow the company the option to avail of the conversion.