What Is a Convertible Note? Examples & How It Works

Cody Cromwell
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What Is a Convertible Note?

Convertible Note: An In-Between Investment & A Money Market Product

In the world of finance, there is nothing harder than coming up with a definition of a convertible note. A convertible note is a kind of investment product that is only popular in the unregulated offshore sector. They’re rarely used in the U.S. and for good reason, so they may never be easy to explain.

For starters, a convertible note is a security that’s said to be convertible into an equity position in a firm. This term, however, is somewhat of a misnomer.

A convertible note can be nothing more than a promissory note, which is not convertible into an equity position. This means issuers are not required to convert their notes into equity. All issuers subject to U.S. securities regulations are required to have an offering memorandum that describes the terms of their notes and a supplemental offering circular that provides an overview of the financial statements included in their offering.

In many cases, issuers of convertible notes have significantly adverse credit quality and they’re not going to be able to pay their loans back. For this reason, issuers must make certain representations and warranties in order to protect investors.

Who a Convertible Note Is Right For

A convertible note is a type of a debt instrument that is issued by a company that is used for raising capital. It is a debt instrument that has an embedded call option and a put option and is convertible into equity in the company at the pre determined conversion price.

A convertible note is able to take advantage of the advantages of having both equity and debt together at the same time and has the following key features.

Companies that issue convertible notes can use up to two part of their capital. The first part is used to fund the company’s non ‘pure play’ operating expenses and the second part is used to fund investments required for growth.

It is important to note that since a convertible note is two part debt instrument, it becomes very difficult for the company to deal with it as the company’s single liability.

This type of a debt instrument is also well suited to funding investments, since you can roll over your convertible note as a temporary measure in case the investment does not return the same value that you expected. In the event that the investment does not return the same amount of value that you expected, you can convert the notes into equity.

As an equity investor, you are at the same time the company’s creditor.

Convertible Note Terms

A convertible note is an investment vehicle that is structured to the investor’s specifications. That is, it allows investors to choose their own security, maturity and optionally, leverage conditions.

A convertible note offers investors protection from sudden drops in the stock price of the company that issued the note or any other counterparty. The investor will have the ability to acquire or exercise the right to buy stock at a pre-determined price and time. If the stock price declines, the investor can always repurchase it at the lower price. If the value of the convertible note itself has increased, the investor can exchange it for more shares of the stock.

The convertible nature of a convertible note is an option that is not required, and all convertible notes do not require an exercise price or a conversion date.

Interest Rate

Discount Rate

Note:

An interest-bearing convertible note is typically a corporate debt security that is payable to the issuer upon conversion. A convert may be a bond, a debenture, or a note; all have legally binding indentures where upon the notes are created. An investor buys a convertible note for its current cash value. The investor receives the cash value less any interest payments, and accrues interest on the convertible.

The convertible typically ranks senior to all debt securities issued against the borrower’s current liabilities. Some of these issuer-sponsored derivative securities, depending on the terms, are designed to allow the borrower, to pay down the debt or even pay it off faster.

The debtor will agree to pay an investor a specific incremental rate of return based on a coupon, and the investor will need to evaluate the ability of the firm to pay back the obligation at maturity.

Valuation Cap

A convertible note, or CoCo, is a loan instrument that converts into shares of stock at a predetermined date. They are traded in the secondary market much like warrants. The holder of a convertible loan instrument is able to purchase the underlying shares at a predetermined price. Unless the debt is called (as is usually the case with a convertible debt), the holder is not responsible for the debt.

In order for a CoCo to be valuable, the shares it converts to must meet trading milestones and must perform well in the market. Performance varies depending on the number of shares underlying the debt and the general market conditions.

Valuation Capability: A hypothetical example

When the market for the shares underlying the debt begin trading at or above the conversion price, it is known as having valuation capability. It is this valuation capability that allows a convertible security to become tradable in the markets.

Callable Debt

Note that even if the debt is not called, it still carries interest and has to be repaid to the issuer at maturity.

There are several industry definitions for a convertible debt. In general, a convertible loan is any type of debt that pays interest and has a conversion price as defined below.

Maturity Date

You can change your cash or cheque account maturity date. The maturity date on a private bank account specifies the day the account will be closed. For example, if you have a cheque or savings account with a maturity date of 30 September, when the day arrives, all your accounts will be closed. Your future cheques and cash transactions will be automatically paid out the morning of the maturity date.

When using a savings account to save up for major purchases such as a home or car, you’ll want the money in your account to be available right away. Likewise, if you’re just making purchases on a monthly basis, you’ll want to keep your accounts open for as long as possible to minimize interest fees. However, if you have a cheque or cash account, it is not necessary to keep your savings open for a prolonged period of time. All you need to do is remember to withdraw the money you plan to spend once the maturity date approaches.

Cash and cheque accounts are not the only types of bank accounts available for Canadians. The most popular are savings accounts, and so the maturity date usually reflects a variable, namely the last day of the month.

While many banks allow you to change the maturity date of your account online, you can also speak to an agent to set your date of choice.

Convertible Note Examples

A convertible note is a type of bond with an optional conversion into a fixed income. The convertible note can be converted to a fixed income and is usually fixed to the market price of the existing shares of the issuer that issue the convertible note. It is a fixed income note and it is not as risky as the preferred stock.

What Is a Convertible Note?

A convertible bond is a kind of bond that is convertible into another security in the company. Convertible bonds are not common in the market today and investors are very excited with the convertible that is issued today. Since the convertible bond is convertible in the future, it is called a convertible note or convertible bonds. This type of bond is convertible into the shares of a company in the future.

How does a Convertible Note benefit the investor?

Convertible bonds or convertible notes are one of the most popular investment plans in the world. This type of bond is made by a company in the market. This bond is a fixed income security that is tied to the market price of the existing shares of the issuer. The convertible note can be converted to another security in the company at its contract value.

How does a Convertible Note work?

Five Convertible Note Examples

By now you’re probably familiar with convertible notes – a new type of security which first popped up a few years ago by securities firms such as JPMorgan and Pershing LLC. These securities are not actually equity, but they can mimic a great deal of traditional equity investments, and they are designed to constitute a tax-inefficient means of generating yield. With the rise of Bitcoin and other alternative currencies, they are also often called

“Bitcoin-equivalent securities.”

You may have heard of convertible notes being used in recent debt offerings by Zenith Media and AutoNation Inc., which contain conversion terms. While these are noninterventional on terms and conditions, there are a few different frameworks that have been developed by various securities firms and are already hitting the market. We’ll look at what they are, and the financial considerations you should make in evaluating them, as well as where they are better than Treasury securities.

Below are five examples of the five different convertible note categories that are currently being used for debt offerings. As you will see, each framework has subtle differences and each has its own advantages and disadvantages.

Convertible Note Alternatives

Treasury Bills, U.S. Government Bonds, Grind Warrants & More

A convertible note is by far one of the most flexible and versatile options you have when it comes to investing in high yield stocks. These types of notes are often referred to as a ”secondary credit” and represent the newer, up and coming trend when it comes to investing.

Convertible notes can be exchanged into shares of stock of the issuing company, and are therefore a great investment alternative to buying shares in the issuing company. As such, convertible notes are more attractive to those who want to diversify their investment portfolios and lower volatility (the risk of a cliff or drop in prices). This is extremely important for institutional investors (large investors such as hedge funds, mutual funds, pension funds, etc.), as they must limit volatility risk within their portfolios.

As long as the issue date is later than the maturity date (when the debt is due), your convertible is likely to behave like a callable security. It can be converted into stock of the issuing company at a specified percentage above or below the issue price.

SAFE

KISS

Financial LLC Loan Review. An Example

KISS Financial LLC is a company that specializes in both short term and long term loans. The variety of loans it offers allows investors to choose the loan that best meets their specific needs. The up front cost of an investor’s investment is usually determined by the type of loan they choose (interest rates can vary).

In a KISS convertible note, the investor has the option of choosing from a short term and long term loan. A convertible note is a private note bond for which KISS is the issuer. A private note bond is a bond issued by a corporation to investors. Convertible notes can be purchased at a discount to face value. Convertible notes can be converted into a fixed amount of stock at a predetermined price. When the conversion is completed and the investor converts their convertible note to stock, the investor will be paid the current market price of the stock based on the current market price at the time of conversion and the conversion ratio.

The principal amount of the convertible note is paid at the maturity date. The difference between the conversion price and face value is the interest paid to the investor. But interest is not paid until the note is converted to stock.

SBA Microloans

An SBA Microloan is a financial product made available through the U.S. Small Business Administration.

The microloan is intended to help small businesses expand or start up in a community or region where credit has been difficult to obtain. In order to be eligible to borrow funds, a business must meet the SBA`s financial and owner-qualification requirements. As it is a loan, you must repay the microloan.

What Is a Convertible Note? Example

A convertible note is a financing instrument similar to a promissory note or term note. Typically, convertible notes are used by companies to pay for issuing equity. In a convertible note, the company gives the investor an option to convert the note into equity in the company. Convertible notes are also used to raise capital without giving an investor voting rights or other rights that other equity securities can provide.

How It Works

A convertible note is a loan with an embedded option to convert some or all of the amount borrowed into equity.

The value of the equity that a note holder receives depends on the investor`s share of the company`s profits after the investment or the note is repaid. As a result of the conversion option, a convertible note is expensive to hedge, which means that a convertible note will make a company`s financial statements look smaller than they would if the company issued simple debt.

Grants

Loans, & Debt Obligations.

A convertible note is a debt instrument issued by a company to a third party. The debt holder does not technically own the company’s assets, but gains the right to loan those assets to the company for interest. These loans are backed by a promise to pay back the stated amount (accrued interest, principle, and some or all future earnings associated with the company) along with the company’s stock or another collateral of the company (such as a portfolio of its debt obligations). This usually requires third parties to give up the underlying asset of the company.

In other words, it’s a way for investors to get ‘theirs’ its’s to gain exposure to an individual company’s assets while gaining control over some future profits…all of which is paid back in the future.

Just like any other debt instrument, convertible notes are a form of borrowing money (and paying back in the form of interest payments) with the intent of making a little bit of profit (for the company and the investor) by holding on to the asset of the company long term.

Pros & Cons of Convertible Notes

Post-Euro crisis, a slew of Central banks and private institutions issued convertible notes as a means of debt restructuring, in order to ease the burden of their debt load. At a glance, the notes seem like a good idea, but the convertibility factor comes with a caveat – convertibility (explicit or implicit) between different currencies.

When the euro crisis erupted in 2010, and the debt troubles in euro zone nations became evident, Central banks began to issue marketable debt in an attempt to ease the pressure on their balance sheet. As a means of debt restructuring, it seems like a good idea. However, the convertibility clause can make them quite burdensome to non-American investors. The threat of being denied access to dollars, due to the restrictions, may make them a less attractive proposition than the debt instruments issued by a private entity.

Colombo Stock Exchange is a subsidiary of the Sri Lanka Stock Exchange and has been functioning since 1989. Colombo Stock Exchange approved an IPO (Initial Public Offering) in January 2000 for Sri Lanka Telecom (STL), a state-owned telecom company.

The IPO priced at Rs. 4.75/share was priced at a 1:1 ratio (the stock was for sale at Rs. 4.75 per share and entire issue was priced at Rs. 9.50 million) for the 10.9 million ordinary shares of face value Rs. 1 each.

Pros of Convertible Notes

Convertible notes (or supranational bonds) combine the protection of a bond with the tax benefits of a convertible security such as an option.

They have a variety of names including "international bonds" and "global notes."

Despite the confusing names, convertible notes are amongst the easiest different types of debt to understand.

Convertible notes are also a great way of diversifying your risk because not only will they keep up with interest rate movements but they rein in inflation unusually well.

With a convertible note, you can choose to exercise your option at any time. In comparison, with a fixed-rate bond, you may have to wait up to ten years before you are allowed to convert it.

Because convertible notes are often denominated in a foreign currency, they are sometimes referred to as "cross-currency swaps."

Many securities are called "convertible" or "callable," which implies they can be converted into another type of security. You can convert a convertible note into another security, like a fixed-rate bond.

Cons of Convertible Notes

Convertible notes are exactly what they sound like. They’re debt securities that can be turned into bonds or sold outright through an exchange. They have a floating conversion rate between bonds and cash, but the price at which bonds are auctioned can be significantly higher than the price of notes sold through an exchange. This results in somewhat of an arbitrage opportunity between the two markets.

However, if convertibility isn’t exercised, then a convertible note is basically a secured debt note. Because of the substantial risk of a conversion premium not being paid in full, convertible notes are often treated as a hybrid securities, between debt securities and equity securities.

One of the key risks of convertible notes is the potential that the premium is not triggered in full and as such the noteholder is not paid the conversion price (and potentially, not even the coupon rate or principal) plus interest until the holder exercises the call option.

Convertible Note Frequently Asked Questions (FAQs)

What is a convertible note? The convertible note is a hybrid loan that converts to equity. With an equity investment, you earn interest, which provides you with income, and you also have rights to participate in the potential upside of the investment company. If you want to convert to equity and become a partner, then you must put a certain amount of money down that you cannot take back. The amount of the down payment varies based on the investment company. I have purchased many convertible notes and the amount was never more than 10% to 50% of the investment.

How does an investment company guarantee that I can get my money back? They have an escrow account maintained by a highly rated, third-party escrow company. Once your investment reaches a certain level, you will be issued a schedule of payments that will enable you to buy back your notes. For example:

  • Investment Company Amount Minimum Investment Amount to Convert Total Amount Invested Funded
  • You can make the downpayment to begin sales and earn money on your investment.
  • You can make the conversion after 5 years.
  • You make monthly payments to continue putting more money down to buy your notes.
  • You can purchase more shares to add to the income you earn on the investments.
  • You to purchase fully participating equity.

Can a convertible note be paid back?

Convertible notes, also known as transition notes or convertible promissory notes, are agreements between parties which typically show transfer of current assets from one party to the other. Generally, a convertible note has three basic components: the money due to the note holder, a conversion price, and a conversion date.

The transfer of current assets, or promise to pay obligations, from the borrower to the lender is completed on the conversion date. On this date, if the note is not convertible for some reason, such as bankruptcy, the transaction will not be completed. Conversion dates are usually between 45 to 90 days after the money is advance or the original promissory note is extinguished.

Banks use convertible notes as a way to borrow money more cheaply than through other credit sources, because interest rates are already low. Borrowers sign up for the note because they are able to get money from a bank at a rate that is less than they could get from a traditional loan. Moreover, the note has a fixed maturity date, while most traditional loans have variable payments and interest rates that are based on the consumer’s creditworthiness.

Basically, convertible notes work by exchanging current assets between the borrower and lender. This allows a bank to extend the loan to a small, non-bank credit source, and the note holder to receive much better interest rates than if they borrowed through traditional means.

What happens when a convertible note matures?

A cash convertible note is one of the hybrid instruments falling under the asset-backed security category. Its structure is as follows: the investor, or investor group in the case of a convertible note fund, purchases the underlying asset in a private placement that is serviced by the issuer. The cash flow generated by the asset is then reinvested in the security, usually at a higher rate of return than the current interest rate offered by any bank. This can be done at the request of the issuer, or annually, usually at the discretion of the investor, which ensures a higher cash flow.

When the term of the note expires, it turns into a variable-interest rate note and the cash flow is either reinvested in another note or returned in the form of interest, to be split among the investors. In some cases, conversion to common stock may also be available for investors at the expiration of the note.

Note that a convertible note is a security which is first issued as a note, and then converts into another form of security such as common stock on the expiration of the note.

Is a convertible note debt or equity?

Convertible notes are debt instruments used frequently by companies in the form of trusts. These notes do not trade like publicly traded companies. Convertible notes fall into the form of debentures and also bonds.

Amongst the two, bonds, securities which are backed by a creditor or a secured promise, make up one category and convertible notes, securities which promise to be converted into stock, make up the second category.

Therefore, although convertible notes offer a high yield, they are not secured by anything. This means that the holder of the note can purchase more stock anytime he wants to. Convertible notes, when converted into stock, are called stock options.

There may be bonds that are also exercisable similar to convertible notes. A convertible note, to the holder, may have a greater return than a similar bond because of two reasons. One, the note holder is younger than the bond holder and, two, the note holder will exercise his option to purchase the stock sooner rather than later.

A convertible note, when converted into stock, provides the holder with stock in the company and the holder is treated the same as any other stockholder of the company.

Convertible note investors can reap great returns over time. Convertible notes are not insurable and come with a greater risk. But for investors who favor a higher return, converting to stock is still a good option.

Bottom Line

For the Trader: Convertible Notes

As the name suggests, convertible notes are also known as provisional notes. But before we delve deeper into the nitty-gritty of this type of security, here’s a character rap from hand.

A convertible note, for our purposes, is a type of loan note that can be converted to equity in the underlying company. The company stands as the principal on the note, and the investors (or note holders) are the sureties (or co-makers on the note).

The amount borrowed is secured in the form of collateral pledged as security for the loan. The collateral is its raw product, and the plant or equipment the creditor is relying on to make good on the loan.

Convertible notes are structurally similar to bonds. But the entire structure is easier to put together, roll out, and sell to investors. And, like bonds, convertible notes can be structured with features that mature at specific points in the future.

Therefore, convertible notes have a very attractive risk-reward pattern to them, which is why they became the investment instruments of choice for some private equity firms.