Explain Convertible Debt
Businesses explore a variety of financing options when planning to expand their operations. These options include issuing stock, borrowing money or selling convertible debt. Convertible debt makes sense for many businesses, but comes with its own set of disadvantages as well. Business owners should evaluate both the pros and cons of issuing convertible debt before proceeding.
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What Is Convertible Debt?
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Convertible debt consists of corporate bonds which include a provision allowing the holder of the bond to convert it to common stock at a future date. Conversion of the bond lies at the discretion of the bondholder. As long as the bonds are held without conversion, the company makes interest payments to the bondholder. If the bonds are never converted, the company pays the face value of the bond to the bondholder at the end of the bond term.
Benefit to Investor
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Convertible debt holds many benefits for the investor. Unlike an investment in common stock, the bondholder is entitled to receive regular interest payments. If the company liquidates, the bondholder holds a legal claim against the company for a return of his investment. At the same time, if the company grows in value and proves to be a good investment, the bondholder can choose to convert his bond into shares of common stock at a predetermined price. If the market price succeeds the predetermined price for the conversion, the investor makes a profit simply by exercising the conversion.
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Benefit to Business
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Businesses struggling to acquire funds can offer a conversion feature to a bond offering. Investors benefit from the conversion feature and are more willing to purchase the bonds. As the company sells more convertible debt, it gains more resources, allowing it to facilitate growth and expansion. Also, as investors convert the debt into common stock, the company eliminates the interest payments and repayment obligation of the bond.
Disadvantage to Business
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Convertible debt also offers disadvantages to businesses that issue this security. Convertible debt requires ongoing interest payments to the bondholders. For a smaller company, this ongoing cash expense may reduce its available cash for growth or expansion. Also, if many bondholders convert their bonds to common stock, the original investors find their percentage of ownership reduced by the influx of new investors.
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