Definition

Convertible debt is a loan that can be converted into equity, often shares of stock in the corporation that borrowed the money, under certain conditions.

Description
 

This financial instrument is frequently employed by startups and expanding enterprises that may require additional collateral to acquire standard loans.

Convertible debentures appeal to investors because it guarantees a fixed return through interest payments, with the possibility of larger returns through conversion to stock if the company succeeds. 

The conversion terms, including date and price, are established and agreed upon before the convertible debt is issued.

Sometimes used synonymously, a debenture is an unsecured loan (not secured by collateral), and when it is described as "convertible," it signifies that the holder has the option of converting the debt into equity rather than receiving cash return of the principal. 

This conversion option often attracts investors because it provides the security of monthly interest payments while also offering the possibility of conversion into equity, which can be beneficial if the issuing company's value rises.

The word "convertible debt" is more generally used, especially in the context of startups and small businesses, although "convertible debentures" may be used more frequently when discussing larger, established firms. Regardless of the language, the underlying traits remain the same.

Different types of convertible debt instruments

Convertible debt instruments occur in various forms, each adapted to certain strategic needs and investment circumstances. Here are some of the major types:

1. Convertible bonds: These are corporate bonds that holders can exchange for a specified number of the company's equity shares. Because of the conversion feature, they often have lower interest rates than non-convertible bonds.
2. Convertible notes: These are short-term loan instruments that typically convert into equity during later investment rounds and are widely used by entrepreneurs. The agreements sometimes contain a conversion discount, which allows investors to convert the debt into equity at a lower price than the valuation at the time of conversion, thereby compensating them for their early commitment.
3. Mandatory Convertible Bonds: Unlike ordinary convertible bonds, which allow the holder to convert at any time, these bonds must be converted into stock by a specific date. The terms of conversion are determined at the time of issuance.
4. Contingent Convertible Bonds (CoCos): These bonds, usually issued by banks, convert into equity only if certain specified circumstances are met, such as the issuer's capital falling below a particular threshold. This feature is intended to provide banks with a tool for automatically strengthening capital during periods of financial difficulty.
5. Convertible Preferred Shares: These are preferred equities that can be converted into a predetermined number of common shares. Unlike bonds, they function as equity and often pay a fixed dividend before distributions are distributed to regular shareholders.

Importance of Convertible Debts for small businesses

Here's the importance of convertible debt for small businesses in 4 points:

1. Funding without Immediate Dilution:  Small enterprises can obtain money promptly without sacrificing equity. This is critical because a company's valuation may be low early.
2. Convertible debt offers a unique level of flexibility: Unlike typical loans, the investor does not receive voting rights but will benefit if the company succeeds. Similarly, the industry is not saddled with fixed interest payments until conversion, resulting in a more flexible financial arrangement.
3. Faster Funding and Lower Costs: Convertible debt can be a quicker and less expensive alternative to raise capital than equity offerings. Legal fees associated with sophisticated investment transactions are minimised.
4. Alignment of Interests: Convertible debt promotes investors to hope in a company's future prosperity. They gain a higher conversion rate if the company performs successfully. This is consistent with the goals of both the business and the investor.

How convertible debts work for startups?

Convertible debt acts like a bridge between a loan and an investment for startups. Here's how it works:

1. Investor Provides Capital: Angel investors or venture capitalists provide funding for startups. This acts similarly to a loan but with a few critical changes.
2. Delayed Valuation: Unlike typical investments, the company's valuation is decided promptly. Businesses in their early phases may need help to obtain an accurate value. Convertible debt delays this decision to a later investment round (such as a Series A).
3. Conversion Triggers: At a set moment, the loan is converted into equity (shares of ownership in the firm). Several events can initiate this conversion, including:

• Maturity Date: If the loan is not repaid by a specific maturity date, it will automatically convert into shares.
• Priced Equity Round: When a startup receives fresh capital at a fixed valuation, the convertible debt converts depending on that valuation and pre-negotiated parameters.
  • Liquidity Event: A startup merger or acquisition may cause conversion.

4. Conversion Terms: The convertible note (the legal document for convertible debt) outlines critical terms like:

• Investors frequently receive a discount on the share price during conversion as compensation for assuming the risk of purchasing early.
• Valuation Cap: This determines the maximum valuation at which the debt can be converted. It protects investors in case the company's valuation skyrockets before conversion.
  • Interest Rate: The convertible note may have a low-interest rate to compensate the investor for supplying funds.

Emerging trends on convertible debts

Some emerging trends for the convertible debts:

Growing Popularity in Emerging Markets: Convertible debt is becoming more common in developing economies. This is owing to its adaptability and applicability for early-stage startups with few traditional funding choices. As these startup ecosystems mature, convertible debt usage will likely rise further.

Rise of Revenue-based Notes: Revenue-based notes, a twist on convertible debt, are gaining appeal. The repayment is linked to the company's future revenue stream, providing greater flexibility for companies with potentially volatile revenue models. This may attract investors seeking profits based on the company's performance without requiring instant large-scale profitability.

The SPV (Special Purpose Vehicle) Structure: This can provide tax advantages and make the process easier for businesses and investors, mainly when dealing with several investors or complex conversion arrangements.

Platform-driven Convertible Debt Solutions: Online platforms are simplifying the convertible debt process. These platforms provide automated document generation, investor communication, and conversion computations. This alleviates administrative burdens for entrepreneurs, allowing them to focus on essential company activities.

Growing Popularity in Emerging Markets: Convertible debt is becoming more common in developing economies. This is owing to its adaptability and applicability for early-stage startups with few traditional funding choices. As these startup ecosystems mature, convertible debt usage will likely rise further.

Example
 

Chai Connect, a smartphone app that helps users find and order tea from local vendors in India, is seeking ₹5 crore (₹50 million) to improve app development, expand to new areas, and increase marketing activities. 

The firm has obtained ₹2 crore (₹20 million) in convertible debt capital from a group of angel investors. This funding will help the startup achieve its goals and allow investors to convert their loans into equity in the future.

The convertible debt issued by Chai Connect has a maturity date of 18 months, with conversion into equity triggered either by a priced equity round or upon reaching maturity. 

Investors are incentivized with a 20% discount rate on the share price at conversion, acknowledging their early investment risk. To further protect investors, a valuation cap of ₹20 crore (₹200 million) is set, ensuring their investment remains advantageous even if the company's valuation significantly increases before conversion. 

The debt carries a modest interest rate of 5% annually, compensating the investors while recognizing their crucial role in providing capital.

FAQ
 

1. What are Fully Convertible Debentures (FCDs)?

Entirely Convertible Debentures are long-term securities issued by a firm that can be converted into equity shares after a specified period. This conversion from debt to equity is usually done under the terms set by the issuing business. FCDs appeal to investors who trust in the issuing company's long-term growth potential since they provide the combined benefits of fixed income till conversion and subsequent equity gains.

2. How do Non-Convertible Debentures (NCDs) differ from Convertible Debentures?

Non-convertible debentures are fixed-income securities that cannot be converted into equity or shares of the issuing corporation. Because there is no opportunity for equity conversion, they usually have higher interest rates than convertible debentures. 

Investors in NCDs typically seek safer, more stable returns without company stock performance exposure. Unlike convertible debentures, NCDs are debt obligations with a fixed maturity and interest payment structure.