To understand convertible bond in startup context, we need to first understand it in the general sense. And in general sense these bonds are issued by big companies to reduce their debt burden. Recently more startups are raising seed money as convertible bond to reduce the hassle and to escape from the nitty gritties of issuing equity.
What is bond ?A big company having high debt may issue bonds to raise money to pay off its debt. People buy these bonds to get interest on their investment. The company fixes a maturity date at which it will pay back the money and till then it pays interest annually/semi-annually/monthly which can be somewhere around 4%-10%. Based on the entity issuing the bonds these are called as corporate bonds, municipal bonds, and Government Treasury bonds, notes and bills, which are collectively referred to as simply “Treasuries.”
What is Convertible bond? (investor point of view)Instead of cash back at the maturity, the investor has an option to convert the investment to get equity/shares of the bond issuing company. This is advantageous to the investor as he has both the option, either to get back this initial investment or to convert the investment to share (if the company is doing good at the time). The amount of stock that a bondholder can acquire is subject to a pre-determined formula. (ex- 10:1/20:1 – 10 bonds equal to one share of the company etc)
Ex: Imagine a public limited company is issuing convertible bond for Rs.100 each with an option to convert the bond-to-shares at a formula 10:1, agreeing to give interest of 5% annually. If you as an investor buy 10 convertible bonds for Rs.1000, you get an annual interest of Rs.50. If the company’s current stock price in market is Rs.600, you will not have any benefit to exchange your bonds for shares as you get 1 share for 10 bonds(for Rs.1000 instead of Rs.600).
But however in the future date if the company performs better (stock price goes beyond Rs.1000), then you may exchange the bonds with shares and get better return on your investment. SO the investor has both the advantage of getting the annual interest + option to go for equity exchange in the future.
But Why do startup raise money through convertible bond? AdvantagesLet’s say as a startup you want to raise debt based funds, as you don’t want to give away equity at the early stage. You find out that the interest rates to raise a loan are too high(bank loans starts at 14%) So to reduce the interest rate on your loan you include an embedded conversion option in the bond. Other advantages are –