At the end of the day, it takes money to make money. We (those interested in finances) know this and so do businesses. Sometimes, however, businesses are looking for an extra buck or two to expand their business internationally or to simply grow. This is where convertible debentures come into play.
Convertible Debenture Example
Let’s start off with an example to understand convertible debentures better. Enter: Sam’s Sports House. Sam’s Sports House is publicly traded on the stock market and is a top-notch sports bar (humor us). Nonetheless, Sam’s Sports House is looking to expand its business and add an additional location in another state. However, Sam’s Sports House doesn’t have enough of its own capital in order to initiate the growth. Therefore, Sam’s Sports House turns to investors to raise capital.
Now, the investors are not 100% sure that expanding Sam’s Sports House is a good idea—it could crash and burn. But Sam’s still needs the cash and offers the investors a convertible debenture. A convertible debenture is a bond with a low-interest rate that is offered by the company (Sam’s Sports House) to its investors. In other words, the investors will be giving Sam’s Sports House the money that it needs on a loan. This loan has a low-interest rate.
The benefit that Sam’s Sports House has in this agreement is that they are able to use the money loaned to them by their investors right away at a low-interest rate. The benefit that the investors have is that they are able to turn their convertible debentures into stocks if Sam’s Sports House does well and is able to expand their business.
Pros & Cons of Convertible Debentures
While a convertible debenture seems like a win-win on both ends if the company ends up succeeding in their plan for expansion, there are also several downsides to convertible debentures.
Pros of Convertible Debentures
For the business…
- The business can use the money loaned to them right away
- The business has low-interest rates
- The business gains new investors and potential shareholders
For the investor…
- The investor receives fixed interested payments from the company
- The investor can convert their loan into having equity of the company
- If the company does not succeed, the investor receives their interest + principal back
Cons of Convertible Debentures
For the business…
- If the business does succeed and the business’s investors want to convert their bonds into shares of the company, this will dilute the current shareholders
- Convertible debentures are a debt to the company, and debt is never a good thing
For the investor…
- If the company goes bankrupt, shareholders are paid-out before convertible debentures—convertible debentures may not receive their interest or principal back
- Companies that have a low credit rating will often turn towards convertible debentures to get the money they need without ever giving the investor a return on their investment—investors should look out for weak companies merely looking to “bend the rules”
What to Look For to Make Money
If you are looking to make money with a convertible debenture, then you should only loan money to companies that have a strong probability of growing or succeeding in their goal. Working with weak companies is a risky business—you might not receive your money back in the case of bankruptcy, as shareholders are paid out first. Long-story-short: work with notable companies or companies that have proven their ability to successfully grow.
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