A Convertible Bond is a short-term debt that converts into equity in conjunction with a future financing round. Convertible Bonds are bonds that can be converted into shares of the issuer at the discretion of the lenders. The lenders would receive equity in the company instead of principal plus interest like normal loans.
Purposes and benefits
A Convertible Bond allows the investor to participate in the upside of an issuer upon IPO or increase in the value of the issuer’s shares. It is less risky than buying the stocks outright as investors can hold onto the bonds as a debt instrument should there be no listing or the share price went down.
Bondholders also have priority over shareholders in the event of insolvency or liquidation.
The value of the Convertible Bonds would be equivalent to that of a typical bond plus an option to purchase the stocks. As it is a hybrid between stocks and bonds, Convertible Bonds typically offer higher yields than stock but lower yields than typical bonds.
Legal documentation required
- Term sheet: This should serve as a summary of the key terms of the agreement between the company and the investors. This is signed at the start of the transaction and before commencing detailed due diligence conducted by the investors.
- Subscription agreement: This document is a contract between the company and the investors which entitled an investor to subscribe for a convertible bond. This agreement should include how the debt is converted into equity, the discount rate and the valuation cap.
- Convertible bond certificate: This is a deed which confirms the purchase of the convertible bond and is a written promise to repay the debt at a specified time by issuing shares.
What is the difference between a convertible bond and a SAFE?
Check out our guide on What is a Simple Agreement for Future Equity (SAFE)?
Both convertible bonds and SAFEs are converted into equity in a future priced equity stage, and both convertible bonds and SAFEs can have valuation caps, discounts and most-favoured-nation provisions.
However, there are a number of differences between a SAFE and a convertible bond:
- Nature: A convertible bond is a debt while a SAFE is not.
- Format: A SAFE is usually simpler and shorter than a convertible bond.
- Obligation: A SAFE does not include interest payment and maturity date, and the company has no obligation to return the invested amount to the investor unless there is a triggering event. While under a convertible bond, the company is expected to make regular interest payments and repayment of the principal at a predetermined maturity date.
- Governing regulation: A SAFE is not subject to the regulation for debt whereas a convertible bond is subject to money lending regulations.
Key takeaways
- A Convertible Bond is a short-term debt that converts into equity in conjunction with a future financing round.
- 3 legal documents are required for issuance of convertible bonds: Term Sheet, Subscription Agreement and Convertible Bond Certificate.
- Although a convertible bond is similar to a SAFE, they differ in aspects including nature, format, obligation of the company and governing regulation.
Bibliography:
- DocPro, “ Bonds / Debentures / Notes / Derivatives” https://docpro.com/cat79/banking-and-finance/bonds-debentures-notes-derivatives
- DocPro, “Employee Share Scheme / Options / SAFE / Incentives” https://docpro.com/cat133/human-resource-employment/employee-share-scheme-options-safe-incentives
