If you are considering starting your own business or have a relatively small company that you are trying to grow, you will likely be seeking outside funding sources. While it may be difficult to get banks to give you the amount of money you need or angel investors to get behind your business, one option that may be viable for you is the issuance of convertible notes.
Convertible notes work like corporate bonds in that lenders provide companies with funding in exchange for a guaranteed “coupon” interest rate. However, as convertible bonds have the option of being converted to shares of stock at maturity, investors are usually willing to accept lower interest rates in exchange for future equity growth.
Because of these dual characteristics, convertible notes have the properties of both bonds and stocks; they are considered a hybrid security. This makes them an attractive option for investors, as the high-upside growth potential combined with a secure coupon payment is not found in most financial instruments.
Types of Convertible Notes
Convertible notes are common for start-ups who need to secure large amounts of capital. They are also prevalent among larger businesses with low credit ratings, which cannot access more valuable funding sources.
There are a couple of different ways investors may choose to structure their convertible notes.
Coupon Rate Payments
By choosing a convertible note with a coupon rate payment, lenders will get a cash payment upon the maturity of the note. The difference is that once the note matures, instead of receiving this coupon rate of interest, plus their initial capital back, the initial money is repaid in the form of shares of stock.
This is generally not a common way for convertible notes to be issued, for a couple of reasons:
- Most convertible notes have meager interest rates, with many notes issued at the lowest legal interest rates for debt financing. The reason behind this is that investors value the growth potential of future equity more than any short-term guarantees of cash through a true bond-like interest rate.
- The coupon rate offered on convertible notes is not in and of itself enticing to investors. If investors wanted higher coupon rates for buying debt, they would be better off purchasing traditional bonds.
To do some math on how a convertible bond with a coupon rate interest payment would work, assume an investor purchases a $100,000 convertible note with a coupon rate of 4% and maturity date of 24 months.
At the end of 24 months, the company would pay the lender $4,000 in cash as the interest obligation and $100,000 worth of stock as principal repayment, say 10,000 shares at $10 each. The number of shares will be entirely dependent on what common shares are trading for.
Again, this is not a highly prevalent way to issue convertible notes, with convertible interest notes being far more common.
Convertible Interest Notes
Converting the interest to equity as part of the repayment of debt is the most common way that convertible notes are issued.
In this case, investors will receive a quoted “coupon” interest rate when purchasing their convertible note.
This rate will still be low when compared to the yield of bank loans and corporate bonds. Still, instead of paying the interest out in cash upon maturity of the convertible note, the lender will receive a proportional share of stock as an interest payment to go along with the original principal being converted to stock.*
Using the same example as that in the previous section, assume that an investor purchases a $100,000 convertible note at a 4% coupon rate and maturity date of 24 months. However, instead of getting the interest paid in cash, the lender will receive their interest in the form of stock conversion.
If common shares are hypothetically trading for $10, the investor will get their principal paid back in the form of 10,000 shares of common stock, with an additional 400 shares tacked on to fulfill the 4% interest payment.
*Note: As a short-term financing instrument, convertible notes typically have maturity dates of 12 or 24 months.
Do Convertible Notes Automatically Convert to Stock?
Whether you hold or issue a 12- or 24-month convertible note, you may assume that the maturity date means that the principal and interest are automatically repaid to the lender. This is another way in which convertible notes differ from traditional bonds.
Convertible notes do not automatically convert at the maturity date. As a matter of fact, it is not really in the best interest of either the company or investor that they do.
For the company, there are a couple of reasons why it is not ideal to convert convertible notes at the maturity date:
- As convertible notes are often used as a form of seed financing, it is highly unlikely that the company will be in a position to issue stock in such a short time frame. If they rush the issuance of shares, the stock will likely be worth little and could hamper the development of the company.
- If all convertible notes had to be repaid upon maturity, it could very well bankrupt the company. The reason it issued debt in the first place was to increase cash on hand for business development, so having to turn right around and pay it back, plus interest, would largely defeat the purpose of issuing notes in the first place.
From the investor’s perspective, it is also less-than-ideal to get paid back upon the maturity of the convertible note. As mentioned, the low coupon rate is not overly enticing for investors who see the opportunity to be an early investor in a company that could potentially increase their initial investment ten times over, at a minimum.
Therefore, note holders would much prefer to be repaid when a round of stock is issued, generally during Series A financing for most young companies.
What Happens if Investors Are Not Repaid?
As repayment at the maturity date is not ideal for either party for this type of short-term security, a maturity date extension is often negotiated between the company and the lender.
This extension will allow the company to continue to use the debt to grow the business to a point where it is in a strong position to issue valuable equity shares at a later date. In return for their patience, some type of lender compensation is often agreed upon, typically in the form of discounted shares upon conversion.
In this case, as compensation for allowing the company to hold their principal past the convertible note’s maturity date, lenders will receive a larger allotment of shares upon conversion.
Using the previous example where shares of stock are issued at $10 per share:
If the terms of the maturity date extension specify that holders of convertible notes will receive shares discounted to 80%, this would mean that a $100,000 note with a 4% coupon rate would receive 13,000 shares (12,500 in principal conversion, 500 more in interest conversion). This is opposed to the 10,400 they would receive if the note were converted at the maturity date.
While it is beneficial for both the lender and the issuing company to negotiate a maturity date extension, there may be some instances in which the investor chooses to foreclose on the company for failure to repay its note upon maturity.
As unconverted notes are technically debt instruments, investors have every right to foreclose on the issuing company and demand repayment of their principal, plus interest. While it is evident that dealing with debt collectors is not ideal for the issuing company, there are several reasons why a foreclosure is a bad idea for the lender, as well, including the following:
- Foreclosure hurts the long-term prospects of the company, as they will be using assets in litigation that could have otherwise been used to grow the business. As such, what is the point of suing to get the shares if the shares you are suing for will be hurt by the fact that you are suing to get them? It is a classic catch-22.
- The foreclosure process will be costly for the lender, as the time and attorney fees involved will likely more than offset any interest gains accumulated from purchasing the convertible note.
- The company simply may not have the ability to pay back the convertible note at the maturity date, meaning that the lender will essentially be suing to get something that may not even be possible to attain.
Given all of these considerations, the best bet for investors who are frustrated by not receiving their converted stock at the maturity date is still to wait.
This will give the company a chance to produce valuable shares that will be worth way more than could have ever been obtained through foreclosure, and in the event that the business fails and declares bankruptcy before the shares can be converted, as a lender, the note holders will get paid back before equity holders from what remains of the company’s assets.
Why Are Convertible Notes Popular as a Seed Investment?
Large companies issue stock as a means of raising funds, but that is years down the road for businesses in their early stages. Banks are unlikely to loan sufficient sums to companies that they view as being high-risk. And angel investors who are constantly petitioned for start-up funds can be challenging to pin down.
Therefore, convertible notes make for a convenient way for young businesses to secure the necessary funding to aid the rapid expansion of their business infrastructure. In addition, the low coupon rate is enticing for companies that may not yet be capable of producing enough cash flows to pay for high-interest debt.
Finally, the mutually beneficial option of being able to negotiate maturity date extensions gives the company some breathing room as their business grows.
From the investor’s perspective, there are many reasons that convertible notes make an attractive investment opportunity.
First and foremost, convertible notes allow the investor to buy stock in a company when the stock does not yet exist. Stock is one of the most desirable assets to own, as the returns possible by holding stocks are ostensibly limitless, provided that the company ends up being successful.
Moreover, by getting stocks upon their initial public offering (IPO), note holders will capture all of the gains that the company experiences.
However, while the growth opportunities are vast when holding stock, stocks tend to be among the riskiest assets because if a company goes bust, equity holders are among the last to get taken care of as the firm distributes its residual assets. This risk is mitigated by the hybrid nature of the convertible bond.
In the early stages of the company’s development cycle in which it is most susceptible to collapse, the convertible bond acts as a debt instrument. This means that the company has an obligation to repay the lenders in the event of dissolution.
When the company is on a much firmer footing and capable of issuing stock, the note holder’s stake turns to equity, giving them much greater growth potential than debt holders. These hybrid features capture the risk mitigation aspects of bonds, but the growth potential of stocks makes convertible notes an extremely attractive instrument for investors.
Downsides to Convertible Notes
While there are many attractive features of convertible notes for both companies and investors alike, there are some downsides, as well, which will be the case with any type of financing.
Share Dilution
For companies, the most significant downside comes in the form of share dilution upon initial public offering. While most IPOs will be huge capital-raising events for most companies, those companies who used convertible notes en masse will not enjoy as rapid an influx of cash.
To begin with, those investors most interested in the company already have a large supply of stock ready-made with the conversion of their notes from debt to equity. And with a large number of shares already accounted for with this conversion, buyers will not have as much ability to drive these watered-down shares up as is common when a long-anticipated IPO takes place.
Capitalization
Another consideration for companies is that due to their early investment in the company, most convertible note holders will want a specific percentage of the company’s capitalization upon receipt of their shares.
As most note holders will want something to ensure that their debt is converted into a certain percentage of the company’s total equity, the business can quickly lose controlling stake of the company when the notes convert. Not to mention that most note holders will not be satisfied with common stock, with the preferred stock giving them voting rights for critical corporate decisions.
Foreclosure
Finally, there is the issue of foreclosure. If the company cannot pay back the notes at maturity, there is the risk that the firm could be in bad shape if enough lenders come at them. While it is not a likely or beneficial occurrence for either party, it can be a headache when dealing with convertible notes, as the hybrid nature of the instrument can give rise to these types of situations.
For the investors, the main drawback to convertible notes is that they lose a little control over their investment. Equity is generally the goal when purchasing this type of instrument, but while ordinary shares of stock are easily tradable, waiting for the debt to mature and the shares to eventually be issued makes this investment highly less liquid than most equity transactions.
Conclusion
Convertible notes do come with interest. Similar to traditional bonds, convertible notes will have a coupon rate that denotes the interest the investor will receive, as well as a maturity date at which this interest is payable, typically a period of 12 or 24 months.
The difference between convertible notes and other forms of debt financing is that upon maturity, the principal is repaid in early shares of stock, with many convertible notes agreeing that interest will be paid in stock considerations, as well. In exchange for this initial equity stake in a high-growth company, investors are willing to accept much lower coupon interest rates for their debt than would be found on traditional bonds.
This hybrid nature of convertible notes combines the advantages of both debt and equity financing. For companies, this can be good in that it opens the door to a larger pool of money that has a long-term eye on explosive equity gains while avoiding many of the hard repayment deadlines associated with traditional debt financing.
For investors, convertible notes give them a chance to receive the explosive gains associated with owning stock while maintaining an initial bond structure that mitigates some of the risks of owning stock should the company prove unsuccessful in its early stages.
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