A convertible subordinated debt (note) is a short-term debt security that an individual can exchange for common stock at the bondholder's discretion.

A subordinated debt is also called a subordinated loan or a junior security. It carries more risk than unsubordinated debt. Larger corporations and other businesses are the typical borrowers of subordinated debt.

Convertible Subordinated Notes

This short-term bond ranks below other loans. In other words, it's subordinate to other debt. It's considered a junior debt or one that's not paid until senior debt holders are fully paid. However, like all debt securities, the note is repaid before stock.

If the issuer goes bankrupt and liquidates its assets, the convertible subordinate note will be repaid after paying other debt securities. When a company becomes insolvent, holders of convertible subordinate notes rank higher than shareholders in recovering capital.

When exchanging convertible securities for common stock, it can be done at a stated conversion price. The conversion ratio determines the number of common shares one can obtain. The note usually offers a lower rate of return since the holder has options. Generally, the higher the value of the conversion feature, the lower the rate of return.

Convertible subordinated debts usually move in tandem with the common shares price. Therefore, when share prices go up, so do notes. When there's significant fluctuation in the ordinary share price, the price on convertible notes is usually volatile as well. Unlike interest rate securities that have fewer price fluctuations, convertible notes present the possibility of major capital gains or losses.

The holder initiates a voluntary conversion, which may happen at any time up the expiration of the conversion feature. Investors that don't convert their notes to equity will receive the face value at maturity, payable in cash. The trust indenture outlines specific dates that note holders are able to exercise their rights to convert securities.

Along with voluntary, conversions may also be forced. The issuing company initiates forced, or mandatory, conversions, and these may happen anytime.

For instance, a company might decide to exercise its call privilege on the security. The company may do this to clear long-term debt from its balance sheet without having to pay cash for bonds. A company may also increase dividends on common stock as a way to get bondholders to convert their holdings.

Subordinated Convertible Promissory Notes

A subordinated convertible promissory note is a kind of debt involving the exchange of a promise of a fixed return. Typically, sophisticated investors are the ones who purchase subordinated convertible promissory notes. The investors usually do extensive research on the company that issues the securities. Potential investors should always be cautious regarding fraudulent notes. Usually, if you see an unusually high rate of return, that's a red flag.

A business's capital structure may be divided into the following categories:

  • Senior debt
  • Subordinated debt
  • Equity

The first tier is senior debt, meaning that senior debt holders are first in line to recover their investment in case of default. After senior debt holders are compensated, subordinate holders come next. Last are equity holders.

With more risk in subordinated debt in comparison to senior debt, there's usually a higher interest rate on subordinated debt so that investors are fairly compensated. Some types of debt have a convertibility feature, allowing the debt to be exchanged for preferred or common shares.

The following are two characteristics of convertible debt:

  • Conversion ratio, representing the number of shares received for each convertible note
  • Conversion price, which is the price per share at which conversion happens

An investor may consider subordinated convertible promissory notes an opportunity to convert into equity shares when a company performs well. They may get an equity-like return. If shares don't perform well, however, the convertibility feature tempers the investor's return.

For borrowers, these types of notes give them the chance to raise non-senior debt and limit interest payments at the same time. Investors often agree to accept lower interest rates in exchange for the convertibility feature.

Savvy investors typically know how to research the right opportunities, and they may be able to take advantage of subordinated convertible promissory notes. Knowing the hierarchy of a company's capital structure helps individuals know when they can expect to recover their investments.

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