Definition
Convertible debt is a type of loan obtained by a company that can be converted into equity shares at the lender’s discretion. In other words, instead of repaying the loan in cash, the lender may instead choose to convert the debt into a predetermined number of shares in the borrowing company. This may be advantageous for the lender if the company’s share price rises significantly.
Key Takeaways
- Convertible Debt is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company or cash of equal value, offering a hybrid solution between debt and equity.
- It is commonly used by startup companies who may find it difficult to give a reliable valuation of their company, thus providing an essentially ‘deferred’ equity round.
- While it functions as a short-term loan, its true power lies in the potential longer-term benefits it can provide if the company proves successful, offering significant upside potential through conversion into shares of the growing company.
Importance
Convertible debt is a significant financial term as it plays a dual role in the field of corporate finance.
Essentially, it is a type of bond that the holder can convert into a specified number of shares of common stock in the issuing company.
Its importance lies in providing companies, especially startups, an excellent way to raise capital with less immediate impact on their cash flow, as interest payments can often be deferred.
On the other hand, for investors, convertible debt offers an opportunity for potential upside if the company succeeds, with the added security of interest income and a claim on assets should the company falter.
Therefore, it provides a balance of risk and reward in financial transactions.
Explanation
Convertible debt, also known as convertible bonds or convertible notes, is a type of investment used by companies, particularly early-stage startups, as a funding mechanism. The key purpose of convertible debt is to raise capital without initially giving up a piece of ownership in the company.
This can be especially advantageous for startups, as they might not yet know their company’s worth and thus may want to avoid setting a specific share price. Furthermore, this allows companies to delay diluting their ownership until they have grown and increased in value.
Convertible debt is used as an incentive to attract potential lenders and investors. The ‘convertible’ feature in the debt offers investors the unique opportunity to convert their debt into equity at a later date, rather than just getting paid back with interest.
Typically, the conversion is made during a subsequent funding round when the company’s value can be more accurately assessed. If the company performs well and the value of its shares increases, investors might convert their debt into shares, thereby gaining a higher return on their initial investment than if they had been paid back the debt with simple interest.
Examples of Convertible Debt
Tesla’s Convertible Debt: In 2014, electric car manufacturer Tesla Motors raised nearly $2 billion in convertible debt to fund the development of its Model X SUV. The convertible notes, with
25% annual interest, could be converted into Tesla stock at a price of around $124 per share. This was successful because the company’s share price surged upwards of $200 per share just a year later, rewarding those who had opted for the convertible debt.
Square’s Convertible Debt: Before its IPO in 2015, mobile payment company Square issued convertible debt to some investors. When the company eventually went public, the stock price was higher than the conversion price, so the debt investors converted their debt into equity, ending up owning a significant percentage of the company.
Twitter’s Convertible Debt Offering: In 2014, Twitter announced a convertible debt offering of $
8 billion. Investors opted for the convertible notes because they believed in Twitter’s potential for growth, and their decision paid off when Twitter’s stock prices rose significantly, allowing them to convert their debt into equity at a favorable rate.
FAQs on Convertible Debt
What is Convertible Debt?
Convertible Debt is a type of loan obtained by a company where the principal or the interest can be converted into a predetermined number of shares of the company at certain times during the lifespan of the loan.
Why would a company choose to issue convertible debt?
Companies choose to issue convertible debt for several reasons. This type of loan could lower the interest rate, as the investor has an added value from the conversion feature. Additionally, it could delay dilution of the company’s shares. Finally, it might be more appealing to investors as they have an option to convert the debt into equity.
What are the risks associated with convertible debt?
The major risk associated with convertible debt is the potential for equity dilution. If the debt is converted into equity, it will dilute the ownership stake of existing shareholders in the company. The company’s financial situation could also be a risk if it fails to repay the debt or if the loan hurts the balance sheet.
What is the difference between convertible debt and traditional debt?
The main difference between convertible debt and traditional debt is the conversion feature. Unlike traditional debt, convertible debt allows the lender to convert the debt into equity shares of the company. Traditional debt requires repayment of principal and interest, while convertible debt offers the potential upside of conversion into equity.
How is the conversion rate of convertible debt determined?
The conversion rate for a convertible debt is decided at the time the agreement is made. It defines the number of shares one can get for a specified amount of debt. This rate may be affected by several factors including the company’s value, the interest rate, and the maturity date of the debt.
Related Entrepreneurship Terms
- Conversion Price
- Debt-to-Equity Swap
- Dilution
- Call Provision
- Convertible Preferred Stock
Sources for More Information
- Investopedia: This site provides a comprehensive understanding of various financial terms and concepts including Convertible Debt.
- Corporate Finance Institute (CFI): A professional training and certification institute providing detailed articles and lessons on financial topics.
- The Motley Fool: Known for its insightful articles on finance and investing, including Convertible Debt.
- Morningstar: Offers investment research and management services and covers various finance-related topics.
