Convertible Debt: Relevance and Features in Basic

Convertible Debt: Relevance and Features

In basic terms, a convertible debenture can be viewed as a means of financing in which case the debt-holder is given an option of converting the debt to stock. Like an ordinary debt, convertible debentures pay the debt-holder an interest. Companies including but not limited to small "dot-com" companies have in the past used convertible debentures to not only raise the capital they require to grow but to also maintain their businesses. Such companies choose to use this means of finance for a variety of reasons.

To begin with, it is important to note that unlike ordinary debentures, convertible debentures have a conversion feature. This feature should be likened to a sweetener. For any small business, attracting capital could prove really difficult. This is more so the case for small startups with unproven profitability and limited operating history. It is important to note that although many small "dot-com" companies had promising futures, their limited operating history was largely insufficient to guarantee them easy access to funds. In addition to offering the usual safety of debt, convertible debentures also offer lenders an opportunity to benefit from probable common stock growth. In the words of Lumby and Jones (2003), "if, at the time of conversion, the market price of the company's shares is above the conversion price, the investor will be able to make a capital gain upon exercising the option to convert." This conversion feature (or sweetener) could have made it easier for the small "dot-com" entities to access funds.

According to Brigham and Daves (2009), "a company with good future prospects might want to issue equity, but it knows the market will interpret this as a negative signal." As the authors further point out, issuance of a convertible debt instrument allows the company to issue equity through the back door. In my opinion, this could have been one of the reasons as to why a number of small "dot-com" companies chose this means of financing. By issuing convertible debentures as opposed to equity, the companies in this case could have tactfully avoided not only the said negativity but also the legal hurdles and costs associated with the issuance of the latter.

Next, the said companies could have settled for the issuance of convertible debentures largely because unlike other means of debt financing, they are regarded relatively cheap. As I have already pointed out elsewhere in this text, the debt-holder in this case is also presented with an option of converting the said debt to equity and hence an opportunity of making a capital gain should the value of the concerned entity's stock rise. According to Lumby and Jones (2003), a company issuing a convertible debenture could make significant savings in terms of interest costs largely because lenders in this case are willing to accept a lower interest rate in exchange for the conversion option. Further, if debt-holders in this case choose to convert the debt into equity, the company is freed from the repayment of the outstanding principle.