Comprehensive Guide to Convertible Securities and Their Features

Convertible securities are versatile financial instruments that combine features of both equity and debt, offering a unique way to raise capital. For startups, these securities are particularly appealing as they provide flexibility to attract investors without immediately diluting ownership. 

As a startup founder, understanding convertible securities allows you to secure funding on favorable terms, often deferring complex valuation discussions. These securities allow investors to loan money or purchase a stake in your company with the potential to convert that stake into equity at a later stage, often when specific milestones are achieved. 

This blog explores the essential aspects of convertible securities, including how they work, their advantages and risks, and their practical applications. Let’s start!

Role of Convertible Securities in Startup Funding

Convertible securities are integral to startup funding because they align with the uncertainties and ambitions that define early-stage businesses. As a founder, you may face challenges in attracting investors without over-committing equity or locking in a premature valuation. Convertible securities offer a practical way to address these issues while maintaining flexibility for your company’s growth.

These instruments are particularly valuable in bridging the gap between short-term capital needs and long-term equity goals. Unlike traditional corporate bonds, convertible securities allow you to secure investments without immediately determining your startup’s valuation. This advantage is especially beneficial in the early stages when your business model is still evolving. By postponing valuation until a future funding round or a predefined event, such as an acquisition or IPO, you gain valuable time to establish clearer financial metrics and market positioning. This delay leads to more balanced and informed negotiations when the time comes.

Convertible securities also facilitate smoother relationships with institutional investors by aligning their interests with your company’s success. The option to convert into equity at a later stage incentivizes investors to support your growth journey rather than focus on immediate returns. This structure encourages a partnership mindset, where both parties share a vested interest in achieving significant milestones. 

Types of Convertible Securities

Here are the most common types of convertible securities that you are likely to encounter during your funding journey:

Convertible bonds

Convertible bonds are debt instruments that give investors the option to convert their bonds into a predetermined number of equity shares. Issuing convertible bonds can be an attractive option for several reasons:

• Lower interest rates: Convertible bonds typically offer lower interest rates compared to traditional bonds, reducing your immediate cash outflow.
• Delayed dilution: You can raise capital without immediately diluting existing shareholders’ equity.
• Investor appeal: The conversion feature attracts investors who want the stability of bonds with the potential upside of equity.

Convertible bonds can be particularly useful for startups in capital-intensive industries or those with longer paths to profitability. They allow you to secure funding without the pressure of immediate equity dilution, giving you more runway to achieve key milestones.

Convertible preferred stocks

Convertible preferred stocks combine features of preferred stocks with the option to convert into common shares. This type of convertible security is particularly popular in venture capital and private equity investments. You might consider issuing convertible preferred stocks because of reasons like:

• Investor protection: Preferred stockholders have priority over common stockholders in dividend payments and liquidation events.
• Flexibility: Investors can choose to remain preferred stockholders or convert to common stock if your company performs well.
• Customizable terms: You can negotiate specific conversion ratios, dividend rates, and other terms to suit your startup’s needs.

By carefully structuring the conversion terms, you can create incentives for investors to support your company through critical growth phases, rather than pushing for a quick exit.

Mandatory convertibles

Mandatory convertibles are a unique type of convertible security that automatically converts into equity shares at a specific date or event. As a startup founder, you might consider mandatory convertibles for reasons such as:

• Lower initial interest payments: These securities often offer higher yields to compensate for the mandatory conversion.
• Predetermined dilution: You know exactly when and how much dilution will occur, allowing for better capital planning.
• Stronger balance sheet: Rating agencies often view mandatory convertibles as equity, potentially improving your company’s debt-to-equity ratio.

By setting a clear conversion timeline, you create a natural milestone for your company to work toward. This can help focus your team’s efforts and align them with investor expectations.

How Do Convertible Securities Work?

Here are the crucial aspects related to the working of convertible securities to help you better understand their mechanics: 

The conversion process

As discussed already, the core feature of convertible securities is their ability to transform from debt into equity. This process typically occurs during a qualifying event, such as a new round of financing or an IPO.

When conversion happens, the security holder receives a predetermined number of shares based on the conversion ratio. This ratio dictates how many shares of common stock the holder gets for each unit of the convertible security. For example, a conversion ratio of 50:1 means the holder receives 50 shares for each convertible bond.

The conversion price, which is inversely related to the conversion ratio, sets the price per share at which the security converts on the maturity date. A lower conversion price results in more shares upon conversion, benefiting the investor.

Investors often decide to convert when the market price of the underlying stock exceeds the conversion price, allowing them to profit from the difference. However, some convertible instruments have mandatory conversion clauses that trigger automatically under certain conditions. Some securities also include a call feature, which allows the issuer to redeem the security before maturity under specific conditions.

Valuation of convertible securities

Valuing convertible securities can be complex due to their hybrid nature. Here, three key concepts come into play:

• Conversion premium: This is the amount by which the convertible security’s market price exceeds its conversion value. A high premium indicates that investors are willing to pay extra for the conversion option.
• Parity value: This represents the value of the convertible security if it were immediately converted to the underlying common stock at the current market price.
• Investment value: This is the value of the security if it does not have the conversion feature, based solely on its income stream and credit quality.

These components interact to determine the overall value of the convertible security. As a founder, you should be aware that the complexity of this valuation process can sometimes work in your favor by allowing for more flexible negotiations with investors.

Market behavior of convertible securities

Convertible securities exhibit unique behavior in different market conditions, reflecting their hybrid nature:

• In bull markets, they tend to behave more like equity, appreciating in value as the underlying stock price rises. This provides upside potential for investors while offering you, the issuer, a lower initial interest rate compared to straight debt.
• In bear markets, they act more like bonds, providing downside protection through their fixed income component. This dual nature can make convertible securities attractive to investors seeking a balance between risk and potential return.

For your startup, this means that convertible securities can be an effective tool for raising capital in various market conditions. They offer investors a level of security in downturns while still providing upside potential during economic growth phases.

Benefits of Convertible Securities

Convertible securities offer distinct advantages for both issuers and investors that can help you better understand how these instruments can fit into your startup’s growth strategy:

Benefits for issuers

• Attracting diverse investor profiles: Convertible securities appeal to a broad range of investors, from conservative ones seeking fixed returns to those aiming for equity upside. This flexibility helps you secure funding from varied sources, strengthening your financial base.
• Preserving cash flow: Unlike traditional debt, convertible securities often have lower interest rates or dividends, reducing the immediate strain on your startup’s cash flow. This is particularly useful during early growth stages, when cash is needed for operational scaling.
• Flexibility in fundraising strategy: These instruments allow you to structure terms that align with your business goals, such as setting conversion triggers based on future valuations or milestones. This flexibility ensures that your fundraising approach evolves with your company’s needs.
• Facilitating strategic partnerships: Issuing convertible securities can help you form strategic relationships with investors who bring more than just capital. These investors may offer mentorship, industry expertise, or networks that accelerate your startup’s growth.

Benefits for investors

• Priority claims on assets: Convertible securities often have provisions that give investors priority over common shareholders in case of liquidation. This added security makes them a safer option than direct equity investments.
• Participation in upside potential: Investors gain the opportunity to participate in a startup’s growth without immediately committing to equity. The ability to convert later, often at a favorable valuation, ensures their investment grows as your business scales.
• Hedging against market volatility: Convertible securities' hybrid nature allows investors to balance risk and reward. The debt or preferred equity component provides stability, while the conversion feature ensures they don’t miss out on high-growth opportunities.
• Tax-advantaged returns: In some cases, the returns from convertible securities may be structured in a tax-efficient manner. For example, long-term capital gains from equity conversion can offer better tax outcomes compared to dividends or interest income.

Risks Associated With Convertible Securities

While convertible securities offer numerous benefits, it is essential to understand the potential risks they bring for both issuers and investors. 

One significant risk for issuers is the potential dilution of ownership. When investors choose to convert their securities into equity, the number of shares increases, reducing your stake in the company. This can become a concern if conversion occurs during a high-growth phase, especially if large portions of your business are tied to equity-based incentives.

Market volatility is another factor that can impact the value of convertible securities. For investors, fluctuating stock prices may result in a less favorable conversion value, particularly if the company’s equity performs below expectations. Issuers, on the other hand, may face challenges if conversion leads to an equity structure that doesn’t reflect the company’s intended financial goals.

The complex terms associated with convertible securities can confuse both parties. Provisions like conversion ratios, caps, and discounts require a thorough understanding to ensure alignment with your startup’s objectives. Misinterpretation of these terms can lead to disputes, delayed funding, or unfavorable outcomes.

The hybrid nature of convertible securities can create accounting challenges. The need to value both the debt and equity components separately can complicate your financial reporting and potentially increase your administrative costs.

When and Why Are Convertible Securities Used?

Convertible securities are versatile instruments used in various scenarios where flexibility and hybrid returns are desired.

Startups often use convertible securities during early-stage funding. When your company is in its initial growth phase, determining an accurate valuation can be challenging. Convertible securities allow you to raise funds while deferring valuation discussions to a later stage, such as a Series A round or acquisition. This flexibility makes them a preferred choice for venture capital and angel investors.

These securities are also valuable for managing cash flow constraints. If you need immediate liquidity but want to avoid taking on high-interest debt, issuing convertible securities can provide a balanced solution. The lower interest rates or dividends associated with these instruments reduce financial pressure while allowing you to focus on scaling your business.

For investors, convertible securities offer a unique blend of fixed-income stability and the potential for equity upside. This hybrid return profile makes them particularly attractive in markets where equity valuations are uncertain, but the company shows strong growth potential.

Convertible securities are also used in strategic partnerships or acquisitions. They can serve as a tool to align interests between your startup and a potential partner or acquirer, providing them with a stake in your company's future success while maintaining your current operational control.

Real-World Examples of Convertible Securities

Here are two notable examples that highlight how startups can use convertible securities effectively.

Airbnb's Convertible Notes

In 2009, Airbnb raised $600,000 through convertible notes to fund its early growth. The notes were structured to convert into equity during Airbnb's Series A funding round. This allowed Airbnb to raise capital without immediately setting a valuation, which was beneficial given the uncertainty of the startup's prospects. The conversion terms included a discount rate and a valuation cap, ensuring early investors received favorable terms when converting their notes to equity.

Dropbox's Convertible Debt

In 2011, Dropbox raised $250,000 through a convertible debt round led by Sequoia Capital. The convertible debt was structured to convert into equity during Dropbox's Series B funding round. This approach provided Dropbox with the necessary funds to scale its operations while deferring the valuation discussion to a later stage. The terms included a discount rate and a valuation cap, similar to Airbnb's approach, which protected early investors from excessive dilution.

Comparing Convertible Securities With Other Financial Instruments

Here is a comparison of key aspects that set convertible securities apart from traditional equity and debt instruments.

Risk and return

Convertible securities balance risk and return, offering the safety of debt-like fixed returns with the potential upside of equity conversion. Unlike traditional equity, which comes with higher risk due to market volatility, or debt, which carries fixed obligations, convertible securities give investors a hybrid option that mitigates extremes. 

Flexibility

Traditional equity involves an immediate dilution of ownership, while debt commits you to regular interest payments. Convertible securities, however, offer greater flexibility by deferring both equity dilution and substantial cash outflows. This makes them particularly useful in managing your cash flow while preserving ownership during crucial growth phases.

Appeal to Investors

While traditional debt appeals to conservative investors seeking predictable returns and equity attracts those prioritizing long-term gains, convertible securities cater to both preferences. Investors enjoy the stability of fixed income and the potential to benefit from your company’s growth through conversion into equity.

Cost of Capital

Raising capital through convertible securities often involves lower costs compared to pure equity or debt. The inclusion of a conversion feature allows you to offer lower interest rates or dividends to investors, reducing your immediate financial burden while incentivizing their long-term commitment to your business.

Conclusion

Convertible securities offer a powerful and flexible funding option for startups navigating the complex world of early-stage financing. As you have learned, these instruments provide unique advantages, balancing the interests of both founders and investors. They allow you to defer valuation discussions, maintain control during critical growth phases, and attract a diverse range of investors.

At Qapita, we understand the intricacies of convertible securities and their role in your startup's journey. Our comprehensive equity management platform, rated as #1 by G2, is designed to simplify the complexities of these financial instruments. We offer tools for cap table management, equity awards, and ESOP design, ensuring you can efficiently manage all aspects of your convertible securities.

Our platform provides real-time insights into your equity structure, helping you make informed decisions as your company grows. With Qapita, you can easily track conversions, manage investor relations, and prepare for future funding rounds.

Ready to streamline your convertible securities management? Book a personalized demo today and discover how Qapita can help you manage your equity like an expert.