Convertible Security Definition: Everything You Need to Know
The convertible security definition is an investment that can be changed into another form. Convertible preferred stocks and bonds are the two most common.3 min read
The convertible security definition is an investment that can be changed into another form. Convertible preferred stocks and bonds are the two most common of these securities. These can be changed into common stock or equity.
Overview of Convertible Securities
Convertible securities work by a company offering these securities to holders for conversion into common stock. At the time of conversion, the common stock is offered at a discounted price. Also, the number of shares issued at the time of conversion indicates the level of dilution.
More outstanding shares are available after a conversion along with lower revenues per share. Individual investors will also possess less of the company. A greater dilution indicates that there is a higher possibility of a decline in the stock's price per share. This results in the need for more shares to be issued in future conversions. If this happens, it may be difficult for the company to attain additional financing.
Overview of Convertible Debt
The concept of convertible debt is to "bridge" companies needing financing in between rounds of equity financing. This is done to help get the company to the next step to either raise financial funds or sell the enterprise.
If the company did not raise a round of financing, the debt converts to the last round of financing or must be repaid. This is why convertible debt is referred to as a bridge loan.
A major concern of convertible debt is the eventual need for it to be repaid if additional financing does not occur.
Most convertible debt that is issued by startups typically has a maturity date one year or later from the time of issuance. When the maturity date arrives, there is always a risk that the investors will demand payment.
One theory states that last-round deals led by venture capital firms are on the decline, which means it will be more difficult for a startup business to raise a new round of financing. There are thousands of startup companies that have used convertible debt to raise money, though, and these businesses may end up defaulting on payments.
A convertible bond allows the bondholder to convert the bond into a fixed number of shares of common stock in the issuing company. Convertible bonds usually have an interest rate, maturity date, and a par value the same as other bonds. A convertible bond, like other bonds, may offer a coupon with prices based on the current market rates and the issuer's creditworthiness.
Firms that issue debt can add a convertibility feature, which makes bonds desirable to investors. The firm may also get better terms and a lower interest rate by adding a convertibility feature. Investors dealing with the convertibility feature have access to a steady stream of income from interest and the opportunity to cash in on future stock appreciation.
It is recommended that investors thoroughly review a bond's prospectus and be aware of the issuer's credit standing before investing. Investors must also be aware that there is a reinvestment risk involved if the bond is callable.
Convertible Securities and Warrants
Common stock is the focus for most investors, but there are other types of investments that combine elements of more than one asset. Convertible securities and warrants are two examples. Many investors do not understand the difference between the two.
- As noted, convertible bonds have an interest rate, par value, and maturity date whereas convertible preferred stock has a stated preference amount if there is liquidation of the company. It will have a set dividend rate that serves the same purpose as a coupon rate does for a bond.
- Investors have the option of exchanging bonds or shares for common stock.
- Each convertible security provides the number of shares received in the conversion along with an expiration date when the security must be converted.
- Many times, conversion is mandatory, but other convertible securities are converted at the discretion of the owner.
- Warrants have no value of their own.
- A warrant owner does not have bonds or shares.
- The value of a warrant comes from its conversion feature.
- Warrants resemble options since they typically require the investor to make an additional payment on a certain date. This ensures that the warrant can be exercised and common stock received in exchange.
- A warrant has a longer lifespan than options and expiration dates of 10 years.
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