Chapter 14

Convertible debt is an instrument that can be converted from debt (liability) to equity shares at some point, often due to a triggering event. Creditors can become shareholders by purchasing the equity share offered in the terms of the convertible agreement. Creditors can often purchase these shares at a discount, and this can be a strong motivator for converting the debt to equity.

There are advantages and disadvantages for a company obtaining its financing through convertible debt.

Advantages

Convertible debt can be simpler, cheaper, and faster, since the debt documentation is much shorter and simpler, with fewer terms to negotiate. As a result, legal fees will also likely be less compared to the fees incurred for a small preferred shares offering. The process can be completed within a matter of two weeks compared to several months for other forms of equity financing.

Convertible debt does not require setting a valuation of the company, as is required for other forms of equity financing in order to set the share price in the offering. In the absence of operational history, it is difficult for most new companies to set a valuation. Moreover, company valuations can create a temptation to over-value the company to maximize the share price at that time. Any subsequent issuance of shares would be priced at the lower market price causing discontent for the original shareholders who paid more for the shares due to the initial over-valuation.

Funds received from convertible debt allow companies to keep control, especially if the conversion is from debt to preferred shares with no voting rights. The company control by existing shareholders will become diluted through the alternative of common share offerings to obtain financing.

Disadvantages

Common shares issuances are commonplace and well understood by investors. Convertible debt, on the other hand, is a hybrid instrument with debt and equity features that can be confusing to investors, thus making the instrument harder to sell.

Prior to conversion, convertible debt interest must be paid, and the principal amount owed must be reported as a liability, even though it may not be payable until a subsequent triggering event occurs. Since convertible debt is considered debt until conversion, its presence in the balance sheet will negatively impact the liquidity ratios, solvency ratios, and any restrictive covenants currently in force from other creditors.

Assuming that the convertible debt converts to preferred shares, some investors may not like the lack of control compared to investing in common shares. To compensate, companies will often add other attractive features to preferred shares, but investors may still prefer to invest elsewhere rather than give up the rights inherent in common shares.

Other Financial Products

Companies can raise capital by means other than convertible debt. A simple loan is one alternative, but this is often difficult for new companies with higher credit risk to obtain. Preferred shares are an alternative with dividends and preferred rights such as voting rights, but this may cause issues for existing common shareholders. Convertible preferred shares are also an option. These are like convertible debt except the loan features such as interest are excluded.

(Source: Scott Legal, 2013)