Convertible debt (also known as a convertible note) is a hybrid security that gives either the investor or the issuer the ability to convert the debt into ordinary equity at a future date. This security contains several advantages to the investor as it offers the downside protection provided by the fixed income debt factor, with an added potential equity kicker on the upside. 

Key terms

Borrower
The party which receives funds with the obligation to repay at a later date. Also referred to as the issuer.

Lender
The party providing funds on the promise of repayment at a later date. Also referred to as the investor. 

Face Value
The principal amount payable to an investor at the maturity date of the convertible security. 

Coupon
The coupon refers to the interest rate payable to the investor and can be fixed, floating or payable at maturity. The amount paid will be a percentage of the face/principal amount. 

A $100 face value debt instrument with a 10% p.a. coupon paid semi-annually will pay investors $5 every six months. When the instrument reaches maturity, the investor receives the face value ($100) and the final coupon payment ($5). 

Maturity
The date when the final coupon and face value of a debt instrument is due to be repaid to the investor. 

Conversion Price
The price at which the convertible debt converts into ordinary equity (shares). Generally, a lower conversion price is more advantageous to the investor as it lowers the price at which conversion can become financially attractive. 

On face value of $100, a conversion price of $0.25 implies that upon maturity, an investor can convert each convertible debt note into 400 ordinary shares in the company. 

The conversion price can also be set as the number of shares which one convertible note can convert into. 

If each convertible note gives the investor the right, on maturity, to convert 1 convertible debt note (with $100 face value) into 400 shares, the effective conversion price is $0.25.

This is varies from a SAFE note which gives investors a guaranteed price discount upon conversion. Hence, a SAFE note's equity upside is not dependent on the prevailing share price at the conversion date but is commonly written as an interest-free instrument. 

Conversion Right
Refers to the holder of the right/decision to convert the convertible debt into shares. In most cases, the conversion right rests with the investor. 

Capitalisation
Refers to how interest coupons are paid to investors. 

  • In a cash income structure, the borrower will be entitled to the coupon rate on the principal/face amount per payment period. 
  • In a capitalised income structure, the periodical coupon payment will be capitalised into the principal. The entire amount is paid to the investor at maturity or conversion.

Security
Refers to the amount of collateral available to the lender in the case of default. 

  • Unsecured: Debt with no collateral backing. In the case of default, the lender ranks behind subordinated debt but above equity. 
  • Secured: Debt with some collateral backing. In the case of default, the lender holds claim to the collateral asset(s) which can be used to recover the debt.

Options
Certain convertible debt instruments offer investors additional incentives such as free options. An option is an instrument which gives the holder the right to buy shares in the underlying company at a specified strike price on or before a specified expiry date. These provide the investor with further upside on positive equity valuation changes.

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