Convertible Notes vs. Equity: Understanding the Difference | Diligent Equity (2024)

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Convertible Notes vs. Equity: Understanding the Difference | Diligent Equity? ›

Using convertible notes or issuing shares is one of the companies' significant decisions when raising investment funds. Though convertible notes can help a startup get its operations up and running, equity doesn't have to be repaid as debt does.

A convertible note is a short-term debt instrument that automatically turns into equity when a predetermined milestone or conversion event occurs. Essentially, a convertible note functions like a business loan that converts into equity instead of being repaid..

Is a convertible note debt or equity? Convertible notes are originally structured as debt investments, but have a provision that allows the principal plus accrued interest to convert into an equity investment at a later date. This means they are essentially a hybrid of debt and equity.

Generally, convertible notes convert into shares (the “Conversion Shares”) at a qualified equity financing round (this term should be defined in the note and usually means a preferred financing round of a minimum size) at the lower of two different prices per share: (1) the price per share using the conversion cap ( ...

Advantages of convertible debt

Companies typically take on convertible debt when they believe their shares will increase in value. This allows them to reduce equity dilution (giving up too much ownership).

A SAFE is a legal contract that gives the investor the right to purchase equity in the future. In contrast, a convertible note is a debt instrument (or loan) that converts into equity at a later date.

The main benefit of a convertible note is their relatively simple structure. Startup financing rounds can quickly become complex and take up significant time and money. Convertible note financings tend to be faster, simpler, and cheaper than priced rounds.

Convertible securities are not classified as debt or equity; instead, they are considered to be a hybrid of the two categories, possessing cash flow features of both bonds and stocks. Convertibles appeal to investors because they provide protection against big losses, and pay higher income than common stock.

A convertible note should be classified as a Long Term Liability that then converts to Equity as stipulated from the contract (usually a new fundraising round).

The equity & liability portion for the convertible bonds can be calculated using the Residual Approach. This approach assumes that the value of the equity portion is equal to the difference between the total amount received from the proceeds of the bonds and the present value of future cash flows.

What is the fair value of a convertible note? ›

The basic concept for valuing a convertible note is the same in theory as the valuation of any other financial asset. The value of the note is equal to the present value of the future income that the convertible note will receive, discounted to the present value based on its associated risk.

Maturity date: Convertible debt typically matures after 12-24 months. At this time, if the notes didn't convert into shares, the investors are repaid their note investment plus interest. Otherwise, the investor can hold their shares to cash out at a later date.

In the absence of protections, convertible bonds almost always dilute the ownership percentage of current shareholders. The result is that stockholders own a smaller piece of the pie after bondholders convert their holdings.

Debt is cheaper than Equity because interest paid on Debt is tax-deductible, and lenders' expected returns are lower than those of equity investors (shareholders). The risk and potential returns of Debt are both lower.

So, by converting debt to equity, you can help protect your personal assets. The main disadvantage of converting debt to equity is that it can dilute the ownership of your startup. If you have $1 million in debt and you convert it to equity, your current shareholders will own less of the company.

Equity capital reflects ownership while debt capital reflects an obligation. Typically, the cost of equity exceeds the cost of debt. The risk to shareholders is greater than to lenders since payment on a debt is required by law regardless of a company's profit margins.

The following are just a couple of the possible disadvantages of using convertible notes as a financing mechanism. If they don't convert, the notes eventually come due. This can result in the end of the startup if the note holders aren't willing to negotiate, and the startup doesn't have the means to pay off the notes.

A convertible note is a form of short-term debt that converts into equity, typically in conjunction with a future financing round; in effect, the investor would be loaning money to a startup and instead of a return in the form of principal plus interest, the investor would receive equity in the company.

A convertible bond is a hybrid security that offers investors the option to cash it in at the end of its term or convert it to shares in the company. Convertible bonds offer lower interest rates than comparable conventional bonds, so they're a cost-effective way for the company to raise money.

What are the disadvantages of convertible loans? ›

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.

Companies issue convertible bonds to lower the coupon rate on debt and to delay dilution. A bond's conversion ratio determines how many shares an investor will get for it. Companies can force conversion of the bonds if the stock price is higher than if the bond were to be redeemed.

LLCs and Convertible Notes

Although LLCs can use convertible notes, it is not common practice because most venture capitalists prefer to invest in a corporation. This preference is due to the following: Corporations provide equity through their shares while LLCs offer ownership interests.

If your startup fails after raising money with a convertible note, your investors will likely lose their entire investment. This is because convertible notes are typically unsecured, meaning that there is no collateral backing up the investment.

When a company borrows money from investors and plans to convert it to equity or ownership in the company at a later time, that's convertible debt. The borrower and lender decide the type of equity and a set time when the loan converts based on the company's value when the loan begins.

Because a convertible note has both debt and equity features, convertible debt is taxed differently in each situation, depending on your rights and benefits as an investor as stated in the underlying agreement. Generally, however, a convertible note carries no tax responsibilities until after its conversion.

To accomplish convertible bond valuations, investors may rely on the following formula: Value of convertible bond = independent value of straight bond + independent value of conversion option.

Similar to regular bonds, a convertible bond comes with a maturity date and pays interest to investors. In addition, if an investor decides not to convert their bonds to equity, they will receive the bond's face value at the maturity.

When the convertible bonds have been issued and sold, the business will take in cash, which will boost assets. On the other side of the balance sheet, liabilities will increase by the same amount, since a convertible bond is a liability.

Convertible notes are just like any other form of debt – you'll need to pay back the principal plus interest. In an ideal world, a startup would never pay back a convertible note in cash. However, if the maturity date hits prior to a Series A financing, investors can choose to demand their money back.

What triggers a convertible note? ›

Convertible notes are a type of loan issued by startups that convert into equity once a “triggering event” occurs. Usually, the triggering event will be the startup's next round of financing that exceeds an agreed-upon minimum threshold, i.e. “qualified” financing round.

A zero-coupon convertible is a convertible bond issued by a corporation that pays no regular interest to bondholders. Because of the zero-coupon feature, these convertibles are sold at a discount and will instead mature to face value if they are not converted prior to the maturity date.

The Disadvantages of Convertible Bonds

There are some disadvantages to convertible bond issuers, too. One is that financing with convertible securities runs the risk of diluting not only the EPS of the company's common stock but also the control of the company.

The maturity date is the date on which the convertible note must be repaid, either in cash or through conversion into equity. The convertible note ceases to exist beyond the maturity date, though both parties may agree that the note may be rolled into a new security.

Rule 144A requires that the conversion price of the convertible notes be at least 10% above the market value of the Page 3 Capital Markets Practice Group 3 underlying shares, but the market generally supports premiums in excess of 10% over the market price of the underlying shares and so this is not usually an issue.

Convertible notes will convert into shares (or be subject to repayment) at predetermined trigger events. These trigger events are usually: the maturity date (when the loan amount must be repaid or converted if another trigger event has not occured);

This doesn't mean you must surrender control of your business, as your investor can take a minority stake. Common equity finance products include angel investment, venture capital and private equity. Read on to learn more about the different types of equity financing.

Interpretation. A high debt-to-equity ratio indicates that a company is borrowing more capital from the market to fund its operations, while a low debt-to-equity ratio means that the company is utilizing its assets and borrowing less money from the market. Capital industries generally have a higher debt-to-equity ratio ...

The main distinguishing factor between equity vs debt funds is risk e.g. equity has a higher risk profile compared to debt. Investors should understand that risk and return are directly related, in other words, you have to take more risk to get higher returns.

Reasons why companies might elect to use debt rather than equity financing include: A loan does not provide an ownership stake and, so, does not cause dilution to the owners' equity position in the business. Debt can be a less expensive source of growth capital if the Company is growing at a high rate.

Is it OK to have more liabilities than equity? ›

In general, if your debt-to-equity ratio is too high, it's a signal that your company may be in financial distress and unable to pay your debtors. But if it's too low, it's a sign that your company is over-relying on equity to finance your business, which can be costly and inefficient.

Tax rates: High tax rates will deduct from bondholders' returns as they will need to give more of their coupon away. Thus, they will demand higher returns to compensate. In this case, issuing equity will be cheaper and vice versa.

The average D/E ratio among S&P 500 companies is approximately 1.5. A ratio lower than 1 is considered favorable since that indicates a company is relying more on equity than on debt to finance its operating costs.

The primary difference between Debt and Equity Financing is that debt financing is when the company raises the capital by selling the debt instruments to the investors. In contrast, equity financing is when the company raises capital by selling its shares to the public.

Basically, Convertible Equity removes the repayment at maturity and interest provisions of Convertible Debt. Additionally, Convertible Equity is “equity” that may have a lower capital gains tax benefit for investors, since it is likely classified as “qualified small business stock”.

A convertible note should be classified as a Long Term Liability that then converts to Equity as stipulated from the contract (usually a new fundraising round).

A reverse convertible note (RCN) is a financial product that shares characteristics with both bonds and stocks by embedding a put option on a bond. RCNs may be attractive to some investors as they can offer higher yields than traditional corporate bonds over relatively short maturities.

The equity & liability portion for the convertible bonds can be calculated using the Residual Approach. This approach assumes that the value of the equity portion is equal to the difference between the total amount received from the proceeds of the bonds and the present value of future cash flows.

Is a note debt or equity? ›

A note is a debt security obligating repayment of a loan, at a predetermined interest rate, within a defined time frame. Notes are similar to bonds but typically have an earlier maturity date than other debt securities, such as bonds.

“What is convertible equity” is a common question among start-up businesses that need additional financing and companies that are at risk of becoming insolvent. Particularly, convertible equity, also referred to as convertible security, is debt that doesn't require repayment when it is matured.