What is Convertible Debt?
Convertible debt, also known as a convertible bond, is a hybrid investment that starts as a bond but can be converted into shares of the company later.
Convertible debt has features of two investment types — bonds and stocks — in one instrument. When investors buy a bond, they are essentially lending their money to a corporation or government at a fixed, pre-determined interest rate, hence bonds are known as debt investments. When investors buy stock, they earn dividends but also own a piece of the company, so stocks are known as equity investments.
How convertible debt works
Specific terms can vary from deal to deal, but in general, the bond aspect of convertible debt has a known maturity date and rate of return, like any bond. The investment will also have a schedule by which the investor can convert the debt into shares in the company. Convertible debt holders are often promised a discount compared to what other investors would pay for the stock. The investor then keeps an eye on the company’s stock price to inform their conversion decision.
When the opportunity to convert comes up, and if the value of those shares comes in lower than the investor would like, the investor could opt to stay in bond mode and settle for repayment plus interest earnings. Investors typically choose to convert if the value of the stock they can obtain is higher than the instrument’s expected earnings as a bond, especially if the company shows potential for those shares to grow in value well beyond the bond’s earning potential.
For investors in the startup ecosystem, convertible debt is often used when investors believe a company is promising but aren’t certain if it will become the next Facebook. If it does indeed boom and the investor exercises their conversion option, they get in early and often at a lower cost than others who didn’t loan the company money via a convertible bond.
A similar element of security is present for the company issuing convertible debt, which explains why this 150-year-old investment type is especially hot in the 21st century startup world. For startups with little to no track record of earnings, often without even a solid valuation, convertible debt gives them access to capital by making investors feel safer about putting their money on the line.
The founders have the assurance that they likely won’t have to sell off their ownership as shares to investors unless they’re doing really well. If they aren’t booming, and the debt doesn’t convert, the startup need only pay back the money borrowed, with interest, without diluting their ownership.
Convertible debt examples
Here are two recent real-world examples of why companies use convertible debt to secure financing from investors.
In May 2021, Coinbase Global Inc., a 10-year-old crypto currency exchange that had only been listed on the NASDAQ for a month at that time, announced it would sell $1.25B in convertible debt. According to MarketWatch, “The platform is now looking to sell bonds due in 2026, which can convert to Class A common stock, if the stock hits a set strike price.”
Coinbase said in a statement, “This capital raise represents an opportunity to bolster Coinbase’s already strong balance sheet with low-cost capital that maintains operating freedom and minimizes dilution for Coinbase’s stockholders.”
What does it need the money for? “General corporate purposes,” writes MarketWatch. The volatility of crypto aside, Coinbase seems confident and simply wants to have the money handy when it can be obtained cheaply.
Then there’s Singapore Airlines, which also announced in May 2021 it would be selling convertible debt, nearly $4.7B worth. This company, founded in 1947 as Malayan Airways, is in a very different position. It was hammered by the Covid-19 pandemic, posting a $3.2B loss following a revenue decline of 76.1% as global travel ground to a halt. Cargo flights were the only bright spot in its year, while passenger revenue fell 98%.
For this company, convertible debt is an emergency reach for capital to stay airborne until the crisis passes.
Convertible debt is a private loan to a company that the lender can convert to common shares in the company at a pre-determined date. It’s a strategy that can benefit both lenders (by reducing their risk and providing the opportunity to gain equity in the company at a lower cost) and borrowers (by avoiding the need to give up too much ownership in the company).