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As a startup owner, choosing a suitable option for raising capital can be daunting. However, convertible debt provides a hybrid form of financing. Initially, it acts as a loan where your startup makes regular interest payments on the loan amount and is obligated by other terms common to the loan. Accordingly, your startup may obtain the appearance of certain benefits common to a leveraged capital structure. This article will consider important legal and commercial factors related to convertible debt financing for startups and leverage.
What is Convertible Debt?
Convertible debt is a hybrid financing approach that blends elements of both debt and equity. Startups often turn to convertible debt because it is one of the few limited financing options readily available to startups.
Convertible debt works in the following way. Firstly, your startup receives a loan amount from one or more lenders. The convertible loan’s terms specify the:
- interest payments, such as 5% payable quarterly; and
- loan’s duration, typically three to 10 years.
However, the convertible debt agreement includes a provision that grants lenders the right (not the obligation) to swap the debt’s final payment demand for shares in your startup. Additionally, the financing agreement specifies the conversion rate and the extent of debt that can be transformed into equity.
What is Leverage, and What Are Leverage’s Advantages?
Leverage refers to using debt as part of your startup’s capital structure, which contrasts with a capital structure comprised entirely of equity financing. Leverage can enhance shareholder value under certain conditions. That said, leverage carries inherent risks, as your startup incurs obligations under debt financing agreements. Ultimately, if your startup cannot meet its obligations, it will default, jeopardising the value of the existing shareholders’ investment in the startup.
We will examine how this operates in practice using two fictional case studies.
Case Studies
Two companies wish to raise £1m in financing. EquCo Ltd will raise this exclusively by issuing shares to outside investors. EquCo Ltd will issue 500,000 new shares in exchange for 1m in cash. This reflects that each share is issued at a premium of £1 (or £2).
BlendCo Ltd will raise its financing exclusively through a bank loan that charges 5% interest per year, or £50,000.
Before the new financing, both companies were incorporated with the same capital structure. That is to say, each company’s founders injected £500,000 in exchange for 500,000 shares issued at £1 each.
A year after the new financing, both companies generated the same pre-tax operating profit of £550,000. The following table explains how BlendCo Ltd can generate more value for shareholders using leverage:
| EquCo Ltd (£) | BlendCo Ltd (£) | Notes | |
| Operating Profit | 550,000 | 550,000 | |
| Interest paid | 0 | (50,000) | 5% interest per year on £1m bank loan = £50,000 |
| Profit before tax | 550,000 | 500,000 | |
| Tax (25%) | (137,500) | (125,0000) | |
| Net Profits | 412,500 | 375,000 | |
| Number of ordinary shares | 1m | 500,000 | |
| Earnings per share (EPS) | 41.25p | 75p | This is the total earnings available to shareholders (net profits) divided by the number of ordinary shares. |
As you can see, the effect of fewer shares in the issue and the benefit of the tax deduction on interest means that BlendCo Ltd appears to have a higher EPS. (Do note that the beneficial effects of gearing would not exist if BlendCo Ltd did not generate sufficient operating profits).
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What is Gearing, and What Are Gearing’s Advantages?
Gearing describes how you use debt to fund your startup’s capital structure. Gearing is advantageous for many businesses because it can increase shareholder value if:
Gearing can increase the value of shareholders under certain circumstances. This is because of two factors:
- interest payable on debt financing is tax deductible, meaning that a startup can generate a portion of its total financing (debt) and repay debt investors via interest payments out of its pre-tax profits, effectively increasing the portion available to shareholders since the government subsidises your interest payments; and
- using debt financing rather than equity does not dilute ownership in the business, meaning the earnings available to shareholders are higher.
Gearing also imposes inherent risks onto your business because you must service the terms of your debt. If your startup fails to do so, you can default on the debt and wipe out the value of the shareholders’ investment.
Case Studies
Suppose that BlendCo’s bank loan is convertible. The loan terms entitle the lender to convert the loan to equity within five years from the date the loan is issued. If the bank exercises all of its conversion rights, it will obtain 50% of the share capital following conversion. This would be identical to EquCo Ltd’s share capital following its equity financing.
In other words, if we treat this convertible loan on the balance sheet as a traditional loan, BlendCo’s share capital appears far more valuable than EquoCo. However, this is not a fair representation of BlendCo’s financing arrangements. EquoCo’s lenders can convert their debt into equity at any point within five years, which would erase the apparent leverage advantages. This is because the equity pool will dilute upon conversion, subject to the terms of the convertible debt.
Practical Considerations For Gearing
Dividends
If startups have issued external financing, external investors will typically restrict the ability of shareholders to issue dividends. This is because startups your startup reinvests all its earnings back into the company rather than extracts them for the short-term benefit of shareholders.
Illiquidity of Private Shares
Earnings Per Share (‘EPS’) is an essential metric for publicly traded companies. This is because higher EPS usually feeds into a higher market price for the shares. However, valuing private companies is more difficult because there is less information available to prospective investors. Moreover, most startups have restrictions on the transfer of shares. This means that a higher EPS under a capital structure with convertible debt is theoretical because you will not be able to readily sell your shares.
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Key Takeaways
Convertible debt provides startups with a hybrid form of financing that incorporates elements of both debt and equity. This form of financing can initially appear to provide the benefits associated with leverage; namely, higher earnings per share. But, if lenders exercise their convertible options, the benefits of debt financing will erode. Startup founders must, therefore, assess the practical and legal considerations of convertible debt financing to ensure it is consistent with their startup’s goals.
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