With convertible debt, a business borrows money from a lender where both parties enter the agreement with the intent (from the outset) to repay all (or part) of the loan by converting it into a certain number of its common shares at some point in the future. The loan agreement specifies the repayment terms which include the timeframe and the price per share for the conversion as well as the interest rate that will be paid until conversion occurs.
The lender can choose to convert the loan to shares according to the “conversion privileges” set out in the agreement. Sometimes the agreement also includes a “callable option” that allows the borrower to force conversion when the value of its shares reaches a certain threshold for a certain period of time.
Lenders like convertible debt because the borrower pays them a fixed rate of interest until they trigger the conversion, at which point they will own shares.
Companies typically take on convertible debt when they believe their shares will increase in value. This allows them to reduce equity dilution (giving up too much ownership). For example, if a business wants to raise $1 million and its shares today are worth $20, it would have to sell 50,000 to reach its target. With convertible debt, it can defer until shares are worth $50 each and issue only 20,000.
More about convertible debt
The following example shows how convertible debt could be set up. ABC Company raises $1,000,000 in debt financing by taking 100 individual loans at $10,000 each with the following conversion privileges and a callable option:
- Conversion privileges—Each loan can be converted into 200 common shares in ABC Company at $50 per share within 10 years. Until that point, the lenders will be paid monthly interest of 4%.
- Callable option—ABC Company can force the conversion of its convertible debts any time after the end of the fifth year and when its common shares have traded at 120% of the conversion price for 25 consecutive days or more.