WHAT IS A DEBENTURE?
In simple language, a debenture is an unsecured loan where the debenture holder holds the right to receive fixed periodic interest payments and the principal back after a predefined period. Debentures are NOT SECURED by any collateral and the interest rates are determined by the general creditworthiness of the issuer.
WHAT IS A CONVERTIBLE DEBENTURE?
A convertible debenture is an unsecured loan which can be or must be converted fully or partially to equity or preference shares. The number of shares which can be received at the conversion is determined at the time of the issue of the debenture.
TYPES – FULLY AND PARTIALLY CONVERTIBLE
1. Fully Convertible Debentures
In case of a fully convertible debenture, the whole debenture is converted to a predefined number of equity or preference shares and the debenture ceases to exist.
2. Partially Convertible Debentures
In case of a partially convertible debenture, only part of the debenture will be converted to a predefined number of shares and other part remains as a debenture.
TYPES – COMPULSARILY AND OPTIONALLY CONVERTIBLE
1. Compulsorily Convertible Debentures
A compulsorily convertible debenture must be converted to shares after a predefined period.
2. Optionally Convertible Debentures
The debenture holder has the option whether or not to convert the debenture into shares.
BENEFITS AND LIMITATIONS
1. For the debenture holders
It is difficult to value the equity of a company which cannot be considered as going concern such as a startup or a company in financial distress. Convertible debentures give investors an option to invest in such companies. Periodic interest payments also give some assured payback.
But, investors should be cautious about the financials of the company. Generally, companies with liquidity issues and lower credit rating issue convertible debentures. The conversion gives the opportunity to share the upside but the investors should do enough due diligence to make sure that there are at least some chances of an upside. Financially distressed companies may issue convertible debentures just to lower cost of debt and the debenture holders may get any benefit from the conversion.
2. For the issuers
Given the high risk associated with companies who cannot be considered a going concern, raising capital becomes difficult. Convertible debentures help these companies raise capital as the debenture holders perceive lower risk with the periodic interest payments.
In case of a compulsorily convertible debenture, the issuer manages the liquidity of the company as the debentures are paid back in kind i.e. in the form of shares. Also, the interest rate for the convertible debentures are lower than non-convertible debentures for the perceived benefit that they can be converted to equity i.e. can benefit from the upside in case the company shared performs well.
Also, the interest payments reduce the taxable income for the company and thus income tax.
Although, issuing convertible debentures instead of equity means that the company will have to make interest payments. For companies with strained liquidity such as a startup, the periodic interest payments can be problematic.