Convertible Debt

In poker, deuces are often called the wild card. You can use the card as a ‘Two’ or as any other card in the deck. In effect, you can convert the card to something else. Convertible debt uses the same principle in business. The holder of the convertible instrument has a choice, continue to collect interest as a debt instrument or convert the debt to equity.

This may appear simple but in reality, there is a lot more to this. There are many different variables involved. More importantly, convertible debt in small business has an appropriate application. This article will explain the technical definition and how the variables impact the situation. The next section will explain why convertible debt is not used in small business and how venture capitalists use the tool.

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Definition and Variables

There are several different terms used as substitutes for convertible debt and they include:

Convertible Bonds
Convertible Debentures
Convertible Notes

All of them are equivalents of the term convertible debt with forms of either restrictions or the type of debt instrument used.

Basically, convertible debt is a loan to a company whereby the lender may at some time in the future convert the debt into equity in the company. Typically the interest rate for the debt instrument is slightly lower than traditional loans because of the value attributable to conversion. In effect, there is value in the ability to convert to equity and therefore the lender has some opportunity. The price the lender pays for that potential opportunity is a reduced interest rate.

Since the interest rate is lower, usually about five to seven % (so a normal 7% interest rate charge would be reduced to 6.65% to 6.51%); there is a conversion premium incentive. Most premiums run between 20 and 25%. For example:

Jim lends $100,000 to Bossco Inc. for a 6% interest rate and the ability to convert to stock in two years with a 20% premium on the face value of the note. If Jim wanted to convert the loan now, he would be only entitled to $80,000 of stock. Right now the stock is trading at $100 per share. In two years, Jim may convert his loan for 1,000 shares of stock. The selling price of the stock in two years is irrelevant; he may elect to take 1,000 shares of stock as payment for the principle on the loan. If the stock is selling for $110 each, Jim could convert his loan to 1,000 shares and then proceed to sell them for $110,000. Jim would make a 6% interest return per year plus $10,000 of short term gain on the stock.

This would initially appear to be a great deal for Jim. But as always, the devil is in the details.

In the publicly traded world of finances, convertible bonds and debentures have more information and track records to determine the respective interest rates and the premium involved. Often, the conversion aspect has a preset stock price or conversion value. As an example:

In February of 2014, TESLA sold $800,000,000 of .25% interest rate bonds with a conversion premium factor of 42.5% based on the stock price on the pricing date On that date, TESLA stock was selling for $252.54 per share. The owners of the notes had to wait at least 5 years with that low interest rate to convert their bonds. Assuming the stock price doesn’t change during that five year period, the bond holder can either get his principle back, or trade in their bond and get 2.7788 shares of stock per $1,000 of bond face value. If the stock price doesn’t change, the market value is only $701.76 worth of stock. But what if the stock price increases during this five year period? Let’s assume it goes to $425 per share. The bond holder still gets 2.7788 shares of stock, but now it is worth $1,180.99.

Immediately the reader should realize that converting the bond today has no value. The real value is in the holding time period. If the company’s stock price increases, the bondholder could get a nice return on his investment. But if the stock remains relatively flat or decreases in value, the bondholder will simply elect to get his principle back at time of maturity. But this opportunity for gain in the value of the stock comes at a price; a lower interest rate is earned on the debt.

The following are the various variables that affect the overall deal:

Effective Interest Rate on the Debt
Time Period to Hold the Debt Instrument Prior to Equity Conversion
Current Premium on the Bond – the higher the premium the less likely the stock’s selling price will eclipse the premium at time of conversion
Collateralize the Debt Instrument – if collateral is used to back the debt instrument the lower the interest rate for the respective bond. In the TESLA example above the proceeds from the bond were used to fund the GIGA Factory Elon Musk is building to manufacture electric car batteries.
Stability of Earnings and Growth of the Company

In general, most convertible debt issues are used to fund a project of some sort hopefully fueling growth which then increases the value of the stock. In effect, it is a win-win scenario for both the lender and the company. This is appealing at the large corporate and publicly traded stock situations, but it is a bit trickier when used in small business. The next section will explain this in more detail.

Convertible Debt – Small Business Application

After reading the above, convertible debt seems like a wonderful way for small business to raise capital to finance operations. Think about it, you simply tie the loan to some function or goal and apply the tool. Dealerships could finance inventory, site developers could purchase more and heavier duty equipment, real estate developers could purchase additional land and more. Why isn’t this tool used more in small business?

A one word answer is: ‘Control’.

You see, in small business most if not all the equity is held by either a single individual or a closely held group like a family. If debt is converted to equity, then some outside person could gain control over the company. The lender would almost demand to have at least 50% of the stock plus one share to have control over the company. In small business, if you don’t have a majority ownership position, your equity is pretty much worth ZERO! It is too easy for those that do have control to drain the profits into their own pockets.

Existing owners do not wish to give up control and lenders would need it in order to financially gain on their investment.

In the publicly traded domain of finances, there really isn’t any need to control an entity but the real goal is to influence the direction of the entity. So large retirement funds and investment groups purchase these bonds and they ultimately influence the company’s direction, culture and goals.

Convertible debt is rarely used in small business and the only time you will see this financial tool is when the company is in the preliminary stages of going public with its stock. Examples of its use are when venture capitalists use the tool to fund the final stages of a new product for the market. Basically all the research is done, the testing is complete, models have been built and government approvals with licenses are issued. Now the product is ready for market and it is time to tool up for production and distribution. Convertible debt is then used by venture capitalists with a requirement that in a certain period of time, the company goes public.

This financial tool is never used at the really small business level. It is simply too expensive and sophisticated for small business.

In summation, convertible debt is very common in the publicly traded world of stock. There is more reliable information for the bond holder to use in analyzing and valuing the risks involved. With small business, lenders of money will not use convertible debt because control becomes a significant issue with the conversion to equity. If your business is growing and is currently a regional operation and you believe you will go public within the next 10 years, convertible debt is an option for capital.

As the lender of money, you would love to have a wild card that could pay off big for you once the deal is done. Convertible debt can be the appropriate wild card. Act on Knowledge.

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