Advantages and Disadvantages of Convertible Debt
In the previous article, we studied the concept of convertible debt and some of the common terms which are used while discussing convertible debt. In this article, we will have a closer look at some of the advantages and disadvantages of using this form of debt.
Advantages of Using Convertible Debt
Many companies continue to use convertible debt. This is because it provides several advantages over plain vanilla debt bonds. The advantages have been explained in detail in this article:
- Beneficial for Start-ups and Risky Ventures: Most start-ups do not have access to debt funding from the market. This is despite the fact that their idea and the initial results may be promising. As a result, investors are often forced to let go of precious equity at a very low price in order to raise funding to sustain and expand their operations. Convertible debt provides a promising alternative to equity funding. Since the downside is limited in the case of convertible debt, investors are often willing to invest in high-risk ventures which may include start-ups.
- Lower Rate of Interest: If a start-up or a high-risk company borrows money from the market, then they may have to pay a significantly higher rate of interest. This is because investors are concerned about the downside risk and the limited upside potential. However, in the case of convertible debt, there is no downside risk and the upside potential is huge. As a result, companies find that they are able to raise funds at a much lower cost of capital as compared to a regular debt issue.
- Controlled Cash Outflow: Companies that are in the growing stage need to have control over their cash outflow. If they were to sell an equity stake in their company at a very early stage, then they would have to pay out more cash in the form of dividends. However, when companies issue convertible debt, they have to pay out a low-interest rate upfront. They can use the balance money to invest in growing the business.
Later, by the time, investors have exercised the option to convert the debt to equity, the company would be at a higher stage of growth. As such, the valuation that the firm would realize using convertible debt is more than the valuation which the firm would realize in other scenarios. Hence, many companies look at convertible debentures as a form of obtaining delayed equity financing.
- Tax Efficient: Convertible bonds are also considered to be quite tax-efficient from the issuing companys point of view. This is because all the money that has been paid out in the form of interest can actually be claimed as a tax-deductible expense. This lowers the amount of tax that needs to be paid to the government, thereby providing a tax shield to the government.
- No Loss of Control: Another advantage of convertible debt is that there is no loss of control as a result of issuing such a debt. The amount of money that is borrowed by the company does not lead to the loss of any voting rights. Hence, companies can continue to conduct their business as per their requirements till the time that these shares are converted and new investors also get voting rights. The ability to operate independently is important for several businesses, particularly the ones which are in their growing phase.
Disadvantages of Convertible Debt
Every financial instrument has its own pros and cons and convertible debt is no exception either. Some of the common disadvantages associated with convertible debt have been mentioned below:
- Dilution of Equity: The first and most obvious disadvantage of convertible debt is the dilution of equity as a result of conversions. If the company makes responsible financial decisions, then the market value of its shares is bound to go up. If that happens, it is only logical to assume that most bondholders would want to convert their debt to equity.
The end result would be a large number of shareholders. Hence, from the next year onwards, the profit will be divided between a larger pool of investors. Hence, each individual investor would earn a smaller earning per share. If companies issue excessive convertible debt, they could face backlash from existing shareholders who would obviously be opposed to the idea.
- Riskier: As we have seen in the above points, convertible debts provide the maximum advantage to companies that are either start-ups or in the growth stage. As a result, a vast majority of convertible debt is issued by firms that are in this stage.
Since these firms generally have a higher risk compared to other firms, the debt that they issue also tends to have a higher risk as compared to other firms. Hence investors who put their money in fixed income securities must be aware that their money is not as safe in convertible bonds as it would be in other bonds.
- Lower Priority: Lastly, it needs to be understood that convertible debt tends to have a lower priority as compared to regular debt. Hence, in the unfortunate event of the bankruptcy of the company, the claim of convertible debt bondholders will be subordinate to the claims of most debtholders. Convertible debt investors will still have a higher claim than the residual claim made by equity shareholders.
Hence, it would be fair to say that convertible debt offers a lot of advantages to certain types of firms. The disadvantages can also be significant. However, if a company is able to plan ahead, then it may be able to mitigate some of the risks that result from convertible debt.
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- Types of Fixed Income Securities
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- Embedded Options in Fixed income Securities
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- Advantages and Disadvantages of Convertible Debt
- Accounting for Convertible Debt
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