Convertible bonds – Everything you need to know
In this article we will look at the specifics of this particular investment instrument, their evolved versions, and how to easily issue them.
Convertible bond is a frequently used term in the startup fundraising network. Whether an investor or a founder, if you are dealing with seed funding of early-stage companies, by now you must be aware of the existence of convertible bonds. But what exactly are they? How do they work?
Issuing shares is the main method of raising operating capital. Shares are issued when the company has been adequately valued for its worth and this company valuation attracts investors. But what about startups? How is a company valuation possible in the early stages of a startup operation? Convertible bond types have evolved precisely for this purpose.
What is a convertible bond?
Convertible bonds are a form of debt security that entitles the investors to receive interest payouts in the form of equity in the issuing company. It is essentially a corporate loan, accruing comparatively lower interest rates on the principal amount, and eventually converting into common stock of the company. This is a hybrid security that combines features of both debt and equity.
However, investors can face convertible bond problems. These bonds follow the share price closely. They are profitable when the company performs well and shares appreciate. But an exception occurs when the share price drops and investors end up receiving only the sub-par price on conversion. Hence, it is important to note the trade-offs.
Convertible bonds have some unique characteristics. These are standard in all convertible bond types, and understanding these terms is important before negotiating the loan agreement. The basic features of a convertible bond are:
- Bond price – amount to be paid to get the bond. This will be the same amount an investor receives if they choose to sell the bond.
- Date of maturity – the date on which the company has to repay the investor with converted equity
- Face value – the principal amount an investor receives on maturity
- Interest rate – the annual interest the investor will receive for the principal invested
- Conversion ratio – the number of shares the investor receives on converting the bond on maturity
- Conversion terms – the predetermined scenarios when the bond can be converted to equity
- Conversion price – (price paid for a convertible bond/conversion ratio)
- Conversion value – (conversion ratio x current stock price)
- Conversion premium – (conversion price x conversion ratio) – conversion value
It is usually up to the investor’s discretion to convert bonds to stock during a bond’s life. Since it is a hybrid security, the price of the convertible bond is sensitive to changes in factors such as the stock price, interest rates, the issuing company’s credit rating, and the likes. Sometimes the company can force conversion of the bonds when the stock prices increase in comparison to a situation when the bonds might be redeemed. In the next section, we will further discuss a company’s perspective on convertible notes.
Why do companies issue convertible bonds?
Convertible bond features are tricky to gauge because what appears to be profitable for the investor will have the opposite effect on the issuing company, and vice-versa. In the previous section, we have gathered a fair idea about how investors profit from these bonds. Here are the two main reasons why companies issue convertible bonds:
- Lower coupon rate – Coupon rate is the yield paid by the issuing company on fixed-income security or debt. Since these bonds have the conversion feature by which the investments eventually convert into equity, companies save on the interest expense which can be quite huge if large bonds are issued.
- Delayed dilution – Dilution occurs with every round of stock issuance. The advantage with convertible bonds is that stock doesn’t need to be issued to investors immediately. Conversion to equity will happen at a much later date (on maturity). With time the company’s net income and share price will grow, and the company will be in a better position to deal with the dilution and may even choose to force conversion of the bonds at this stage.
Types of convertible bonds
Convertible bonds are increasingly becoming a popular choice for startup investments. Based on their features, the following are some different types of convertible bonds:
- Vanilla convertible bonds – This is the most common convertible bond. Conversion price and the rate is pre-determined for the eligible number of shares, and coupon payments may be paid during the bond’s term. If the share price appreciates, these bonds are converted into shares while they remain as bonds if the share price drops.
- Mandatory convertibles – In this case, investors are obligated to convert bonds to shares on maturity. This convertible bond features two types of the conversion price. One limits the share price at which the investor will receive an investment equivalent in equity. The second limits the price that the investor will receive the above par value.
- Reverse convertibles – These bonds favor the issuer. They give them an option to buy back the bonds from the investor either in cash or convert them into equity at a pre-determined conversion price and rate, on maturity.
- Convertible to preferred – Standard issue convertible bonds convert to common stock. But with these types of convertible bonds, they convert to preferred stock where the principal is not guaranteed, yet they provide high dividend rates.
- Exchangeable bonds – These have a unique feature of being converted into equity of another company. They can also be exchanged for an underlying blue-chip stock to increase demand for the bonds.
- Contingent convertible bonds – Also known as CoCos, these convertible bonds are popular in an European investing scenario. They work similar to convertible bonds, but attract high-interest rates, and are designed in a way to protect the issuer from capital loss. They were specifically created to help undercapitalized banks and prevent a global financial crisis similar to 2007-2008. However, US banks do not use CoCos, they issue preferred shares instead.
- Foreign currency convertible bonds – These allow the issuance of bonds in a foreign currency. They come in handy when the company raises capital in a foreign currency stronger than the domestic country.
Pros and Cons of Convertible Bonds
Convertible bonds provide the flexibility of funding early-stage startups without undergoing the entire process of a company valuation. Moreover, in the early stages it is difficult to arrive at an exact value of a startup, as it is just gathering speed. Investors make a profit betting on the growth potential of the startup and founders receive the much-needed funds to scale up operations. However, the risks and rewards need to be weighed with care.
Pros of convertible bonds
- Fixed income for investors – Convertible bonds are technically loans and are legally required to carry interest rates. Hence an investor is sure to receive a fixed income with the accruing interest rates. On maturity, the cumulative fund (principal plus interest) will convert to equity. Higher the stock price, higher the convertible security. Besides, investors receive default security as they will be paid before common stockholders, in case of a sellout.
- Deferred stock dilution for issuer – Every round of share issuance results in dilution. But convertible bonds allow delay in dilution while securing the necessary funds. Companies don’t need to issue shares to their investors immediately, and the principal along with the accrued interest will convert to equity only on maturity. Meanwhile, the share price will appreciate, enabling the company to be in a better position to handle dilution.
- Tax advantages for issuer – Payments on interests are tax-deductible. Thus convertible bond features allow the company to take advantage of interest tax savings, which is not possible in equity financing.
Cons of convertible bonds
- No control in company matters – Common stockholders enjoy voting rights in the company while convertible bondholders do not. As an investor, in addition to taking a risk of backing a seed-stage startup, not having a say in the business may be a point of discouragement.
- Risk of bankruptcy – Investors buying company stock do so after tracking the business performance as they usually have sufficient data to make informed investment choices. This is not the case with convertible bonds. Investors at this stage are mostly backing a promising idea with growth potential. Hence, at times the startup may not be profitable as expected, resulting in bankruptcy.
How do Convertible Bonds work in Private Companies?
In a startup, relying on private equity seed funding builds the foundation for further financing rounds. But founders constantly find themselves navigating complicated fundraising negotiations. Sometimes in a rush to secure investors, they may make the mistake of striking a deal that provides immediate funding but will become a liability later. On the other hand investors might place their faith on an unyielding business losing all their money.
Types of Convertible Notes in Private Companies
There are three standard form documents: standard notes, KISS, and SAFE. These are called standard form as their formats fix most of the terms and considerably reduce the number of negotiating points between investors and the startup. Engaging parties can simply choose their suitable format and quickly close the deal. Let us discuss one by one.
A standard note provides a flexible financing option for companies. This type of convertible bond features hybrid security of debt and equity. On one hand, they act as a bond accruing interest rates, and on the other hand, they present an opportunity to own company stock. The conversion ratio feature determines the number of shares the investor is entitled to on conversion.
An additional advantage is that standard convertible notes do not force the issuer or the investor to determine a company’s value while negotiating investments. This truly saves seed-stage companies from undervaluing their worth in a mad rush to secure funding. Seed-stage investments can range anywhere between $100,000 up to $1.3 million.
Since startups are increasingly opting for convertible notes to raise seed money, efforts have been made towards standardizing the legal documents. Convertible bonds further paved the way for two standard form documents (KISS & SAFE) which aim to simplify startup financing by standardizing the process. These were created by two startup accelerators, 500 Startups (KISS) and Y Combinator (SAFE). Investors and founders now can agree on either of these standard forms, thus reducing the list of negotiating terms.
SAFE, also known as Simple Agreement for Future Equity, allows the initial stages of financing transactions to move forward with ease. They defer conversions to future equity rounds, so many consider SAFEs to be truly safe as it does not include severe clauses that may jeopardize the startup. In a way, to the dismay of the investors, SAFE protects the company’s interest.
However, in favor of the investors, SAFE contains provisions for an early exit in case of company dissolution. Investors and the issuer have the possibility of negotiating the valuation cap that will protect the interests of the investor. Based on this clause, in case the company goes on sale before conversion to equity, the investor can opt to either receive the original investment as is or convert the value to equity per the valuation cap.
SAFE protects a startup with extremely narrow terms to the extent that Y Combinator created four different contracts to avoid complexities. The only open negotiating points are the decision to include and the amount of a valuation cap and discount price on conversion. The four different types of SAFE are:
- Cap, no discount
- Discount, no cap
- Cap and discount
- MFN (most favored nation), no cap, no discount
With SAFEs, investors may run the risk of losing their investments in case the startup fails to raise future rounds of equity capital. Hence the issuer and the investor need to study all clauses carefully before proceeding.
These are some SAFE clauses:
- Allows equity purchase
- No maturity date, no due date as well unless negotiated
- No interest rate
- No options for minimum financing rounds
- Valuation cap/discount available
- Transfer rights provided to investor affiliates only
- Conversion happens into next equity round
- Sometimes MFN
KISS, also known as Keep It Simple Securities, is similar to SAFE in aspects of minimizing endless rounds of discussions before the grant. But KISS differs from SAFE in many ways. Unlike SAFEs, which do not qualify as a convertible bond, KISS accrues interest at 5% and provides a maturity date of 18 months. KISS also contains the MFN clause (SAFE does not) that allows an investor to receive better securities of the company if it chooses to issue in the future. This feature protects the interest of the investors risking early investments in a startup.
For example, once the company raises at least $1 million in equity financing, KISS will convert to preferred stocks. However, both parties have to negotiate a valuation cap and the discount on a deal-by-deal basis. In case the company goes on sale before the conversion, the investor will be eligible for 2x their investment or convert as per the valuation cap. KISS has another unique feature. It identifies major investors as those who invest at least $50,000. Additional rights (eg. Right to financial information, 1x participation in future rounds, etc.) are provided to these investors.
Investors can transfer KISS to anyone at any time. The two types of KISS are:
- Debt version – specifies interest rate and maturity date
- Equity version – does not specify the interest rate and maturity date. This is a midway deal between convertible debt, KISS & SAFE.
KISS clauses are:
- Maturity period is 18 months
- Interest rate fixed at 5%
- Minimum financing round > $1 million
- Valuation cap and the discount has to be negotiated specifically to the deals
- Can be transferred to anyone at any time
- The premium on exit – convert in 2x
How Convertible Notes Work (with example)
As discussed, convertible bond features are similar to loans. But their application varies depending on negotiations around three terms: interest rate, discount rate, and valuation cap. Based on these terms, five different possibilities arise:
- Applying only interest rate and functioning as a regular business loan
- Applying only a discount rate enabling the company to defer until the actual valuation is known in the next financing round
- Applying interest and cap, thus doubling the cost of funding for the company
- Applying discount and cap, thus increasing the overall discount per share. This works in favor of the investor but increases the cost of funding significantly
- Applying interest, discount, and cap, leading to the most expensive option of fundraising
Here is a simple example of a convertible bond offering interest and cap. Imagine a company issues a note of $1,000 par value with a 5% coupon and 5 years maturity. The conversion ratio offered is 25. Thus the effective conversion price stands at $40 per share ($1,000/25). Let us assume that the investor holds on to the bond for 3 years drawing a fixed income of $50 each year (5% coupon).
Now there are two scenarios:
- Share price increase – After three years if the share prices increase beyond the conversion price, eg. $60 per share, the investor will choose to convert thus receiving the predetermined 25 shares for a total value of $1,500 (25*$60). In this case, notes are profitable as they provide added income along with the chance to participate in the profits of the underlying stock. However, there is a risk of being callable, and the issuing company can choose to call away the bonds and cap the investor gains.
- Share price decrease – If after three years the share price drops below the conversion price, eg. $30, the investor will move to convert and hold on to the bonds until maturity. Interest will pay $150 over the years and they will get back $900 as well.
Here is how the scenario would look like:
|Conversion Ratio||25 shares|
|Price per share||$40|
|Share Price Increases to||$60|
|Total Value||$1,500 + interest ($150)|
|Share Price Decreases to||$30|
|Total Value||$750 + interest ($150)|
Now imagine handling multiple investors with varying bond terms. It could be quite a task! But there are ways to automate and streamline this process. Eqvista is one of the leading providers of this service. Let us take a look at how simple issuing and managing convertible notes could be.
Converting notes on Eqvista (Round Modeling analysis)
Round modeling is a tool that helps investors and the company management to view dilution along with the introduction of new investments with their convertible bonds. To grow a company, it is important to understand the workings of this feature that will in turn help to make crucial decisions about the financial future of the company.
Eqvista’s round modeling tool has the following unique and advanced features that are not easily available in other services:
- Immediate reactivity to data input
- Allows multiple inputs for date of investment, investment amount, and pre-money & post-money valuation
- Availability of basic and advanced version of new investments
- Pre-money and post-money convertible basis
- Preferred shares have options to include conversion rate
- Convertible notes have convertible note interest options
- New investments supported by graph charts & key figures.
Most other platforms display only the basic features, but these features make Eqvista round modeling a leading financial tool for startup founders and investors. They can test different scenarios with multiple functionalities. You can learn more about the Eqvista round modeling tool and how to use it on this platform.
How can Eqvista help you?
Eqvista is designed for the new age entrepreneur. It is a one-stop destination for issuing, managing, and tracking company shares. Founders need not burden their already busy schedules with cumbersome paperwork or myriad financial consultations. Eqvista provides an answer to most of your company’s equity operations. You are just a step away. Register with us today!