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 done on the basis of a predetermined ratio on certain points in time. If an investor chooses not to convert the debt, they are repaid their initial investment back 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 in the future these debts can be converted into equity instruments of the company.
Convertible debt instruments provide debt holders with some advantages. They provide the debt holders with extra security as they have the option to not 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, in the case of liquidation of the company, convertible debt holders will be paid off first before its equity stockholders.
For companies, particularly for startups, convertible debts provide an alternative source of funding. Investors generally avoid investing in startups’ equity instruments due to the risks associated with them.
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 in lieu 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 be disadvantageous as well 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 which is 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 point in 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 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 while investors prefer convertible debt instruments with earlier maturity dates because it decreases the risk of their investment.
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 convertible debts.
Vanilla convertible debts are the most common type of convertible debts. These give the debt holder the option to convert the debts into common equity shares at the maturity date at a given convertible rate.
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.
These types of convertible debts are generally offered by established companies.
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 5% interest rate.
Furthermore, the convertible debt instrument has a maturity date of 7 years. At this point, the common shares of the company are traded in the stock market for $48.
In the above example, the convertible debt holder has the option to hold their convertible debt until 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 until and also including the maturity year. This means they will receive a total of $1,350 ($1,000 principal and $350 interest) at the maturity date.
If the common shares of the company 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 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 as compared to equity instruments. Convertible debts also have other types that may allow the company the option to avail the conversion.