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Convertible debt buyers may be looking to take over company

Denver Business JournalOn the Money
From the October 3, 2008 print edition

When raising cash for a new company, there are basically two things that a firm can do:

  • Borrow money from a lender in exchange for a promise to pay later.
  • Or, accept money in exchange for stock. Debt holders receive a promise to repay in cash. Equity holders become part-owners of the firm.

When these two methods are combined, the arrangement becomes a “convertible debt.” A convertible debt (or convertible debenture) is a type of loan that can be converted into shares of stock rather than be repaid in cash, usually at some predetermined discount rate.

The investor in the new company then has the best of both worlds – a promise of specific cash repayment, or if the new company does well, the ability to become a stockholder and share in the success.

This type of security is especially favored for publicly traded companies, because there’s already a trading market for the stock. However, there is a dark side to convertible debentures that’s worth exploring.

Since the conversion to shares of stock is based upon the price per share, the company’s wants its share price to rise so that it relinquishes less ownership percentage to the investor – the “holder” of the convertible debenture. On the other hand, the lower the stock price per share, the more ownership percentage the investor receives in exchange for the funding.

For example, a company borrows $10,000, its share price is $1, the conversion discount rate is 10 percent and the firm has 100,000 shares outstanding. If the stock price remains at $1 per share, the holder of the debenture will be repaid with 11,111 shares of stock ($10,000 divided by 90 cents), representing a 10 percent ownership in the company.

However, if the share price drops to 25 cents per share, the investor will be repaid with 44,444 shares – almost a 31 percent ownership share. Simply put, the lower the price per share, the more ownership the investor receives.

Therein is the danger. If the investor has an underlying motive to take control of the company, they’ll attempt to make the conversion price as low as possible – forcing the firm to issue enough stock so that the investor becomes the controlling shareholder.

Investors usually demand certain conversion provisions before the initial investment. So here are some warning signs that a convertible debenture is actually a snake in the grass, coiling to take over the company.

  • Multiple conversion provisions – The heart of the convertible debenture is its conversion provision. In a friendly debenture, there will be one conversion event for the total amount of the investment. If there are multiple conversion events specified in the documents, for only a portion of the amount invested (the actual amount being determined by the investor), the unfriendly financier is attempting to control conversion over time while the share price declines.
  • Penalty provisions that change the discount, not the interest rate – In typical loans, late payments usually trigger an additional payment, the “late fee,” in the form of cash.

However, if penalties are expressed by an increasing discount rate, it’s a clear sign that the investor is after ownership of the company, not being repaid in cash. This provision is particularly dangerous when penalties are tied to time. For example, the discount may increase 1 percentage point for each five-day period the payment isn’t made.

  • Restricting what the company can do – The convertible debenture may attempt to specify how the money can be used. The documents also may state that the company can’t issue stock to anyone else – a “first right of refusal.” Management then is handcuffed and loses its ability to satisfy and be released from the convertible debenture. It’s a clear sign of a takeover attempt.
  • Events of default – The unscrupulous investor will construct events of default that trigger forced conversion of the entire debt. If the stock price is falling, and the investor has the right to acquire stock at a substantial discount to market, an event of default could quickly force the company to issue so much stock that the investor becomes the new owner overnight.

Some examples of exploding events of default are:

  1. Failing to file a required disclosure soon enough.
  2. Failing to issue the stock within an inordinately short time period, such as one or two days.
  3. An unrelated small judgment against the company, such as a credit-card dispute or contract litigation.

While convertible debentures offer advantages to the young company, they can also be dangerous. It’s very important to assess the motives of the investor, carefully examine the documents for warning signs, and closely watch the investor’s behavior with other companies in the market.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.