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Types of bonds
Convertible notes do not mandate conversion. They give an option to the bond holders at the time of conversion and it is on their discretion whether they want to convert and get equity shares or opt out and get cash against these bonds. Company Reliant issues convertible bonds. Information associated to these bonds is as follows:.
Since, the convertible bonds have features of both liability debt as well as equity, it makes more sensible to account for the liability portion and equity portion separately. This will help to give a true and fair view of the Financial Statements of the organization because of the following two reasons:.
The Handbook of Hybrid Securities - The Handbook of Hybrid Securities - Wiley Online Library
Let us go through each one of them in detail to understand the entire flow of accounting for convertible bonds. If you are new to bonds, do have a look at Bond Pricing. The split between equity and liability portion needs to be accounted for at the time of issue of bonds itself. This approach assumes that the value of the equity portion is equal to the difference between the total amount received from the proceeds of the bonds and the present value of future cash flows from the bonds.
Liability portion of the convertible bonds is the present value of the future cash flows, calculated by discounting the future cash flows of the bonds interest and principal at the market rate of interest with the assumption that no conversion option is available.
Value of the equity portion will be the difference between the total proceeds received from the bonds and the present value liability portion. On a yearly basis, coupon payments will be made to the bond holders. As mentioned earlier, convertible bonds are issued at a lower rate of interest. The difference between the effective interest and nominal interest will be added to the value of liability at the time of interest payment. Food for thought : As you must have noticed, the liability value keeps increasing year after year and at the end of year 5 it is equal to the face value of the bond.
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The total amount added up to the Liability each year will be equal to the Equity Options amount we have arrived at the time of issue of these Convertible Bonds. Also note, the equity section of the Convertible Bonds will not change during the life of the bonds. This will change only at the time of conversion or payout, as the case maybe. Say someone asked you to be an investor in their company, but all they had was an awesome idea. This is how convertible notes were born. They allow investors to bring money to the table early on in a startup and convert that debt into equity at a later time, with special terms that make their earlier investment worthwhile.
The benefit is that entrepreneurs and startups can get funding without having to define the value upfront and investors can take an early stake in the company. There are three main unique features of convertible notes, besides the maturity date we mentioned above.
Whichever term ends up being more valuable to the investor at the time of conversion is the term that will be upheld. Be aware, all these terms will cause dilution but how much dilution occurs depends on how extreme the terms are. In part III of this series, we will break down how to calculate convertible debt into equity on your cap table. This is exactly what it sounds like. Convertible notes are a debt instrument and are legally required to carry interest. However, most of the time the interest will be set to zero or the lowest interest rate legally required.
The exception to the rule: There are other types of convertible securities that are mainly used at accelerators like Startups and Y Combinator. This is done to avoid putting pressure on the company they are nurturing. More on this in part II.
Interest rates have two accrual methods, simple or compounding, and they usually carry a time frame for when and how the interest rate is calculated. Think of the monthly interest that accrues on your car loan or mortgage. These terms are all negotiable, but interest is pretty standard. And debt is required to pay interest. You can also scroll to the bottom of this article for more details on how to protect yourself from malicious terms.
A conversion discount negotiates a lower share price when you convert your note to stock. When you have a convertible note, that debt will convert to equity in the next preferred round of financing, a series seed, A, B, C, etc.
- Zero-Coupon Convertible.
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The phrase, more bang for your buck, could sum up what a conversion discount does and why an investor would want this term included. Ok, now for the trickiest of the terms. Valuation caps, also known as conversion caps, place a limit on the value of the company so that the note converts at no more than the agreed-upon cap.