Debt Exchangeable for Common Stock - DECS
Convertible Debt is just normal debt...but with one potentially, highly valuable added feature: It’s convertible into something else. In this case, it's convertible into common stock. If we were Marvel Superheroes, that would be our super power. "Financeman"…or something like that.
Anyway, example time: Drone Ranger, Inc. needs money to upgrade a factory so that it can produce drones that don’t just fly...they swim, too. Prevailing interest rates for its level of risk and creditworthiness are 7%. The company needs to raise $100 million, and the idea of paying 7 million bucks a year for that debt is just too high a price. So the CEO balks. Says no…no new factory for you.
But if the company could get the debt cheaper, then she might, uh...un-balk. Unfortunately, the company’s stock trades today at a very low multiple of earnings...only 15 times the dollar a share they’ll earn this year. So they don’t want to raise the $100 million by selling equity.
It would be dilutive to do so. Meaning that they would have to print too many new shares to raise that $100 million...specifically, 100 million divided by 15, or 6-and-a-half-ish million shares. Some of the company’s investors (or rather, all of them) believe that the company’s stock is and/or will be worth more per share than it is today. Otherwise they wouldn’t own the stock, right?
So the wily CFO of the company wonders if there’s a Miley Cyrus best of both worlds solution here where you could sell equity at a higher price in part for a price decline on the debt. And, in fact, there is. And...yeah, you guessed it. It’s called convertible debt. Uh, different kind of conversion.
The Drone Ranger’s stock is $15 a share today, but through careful negotiated back and forth with the capital markets people at an investment bank, the company learns that there actually is demand for its debt priced to pay only 3% interest…if that debt is convertible into equity at $30 a share.
So what does that mean? If the stock stays under 30 bucks…well, pretty much forever, the buyers of the debt...or lenders of money to the company...got taken. That is, they only got 3 percent interest on their money when they should have gotten 7 percent. But if the stock takes off and the overwater/underwater drones really uh...fly off the shelves...then the convertibility feature of the debt will be exercised or used. Which would be a good thing.
So the debt is convertible at 30 bucks a share, which means that the $100 million raised would cause the company to be diluted 100 million over 30 bucks or x shares...i.e., half the dilution it would have taken had it just sold shares at 15 bucks each. It essentially wrote a call option to the buyers of the debt to be able to buy its stock for 30 bucks, or 30 times the current year’s earnings at some point…whenever...in the future.
So...yeah. That’s convertible debt. Not what you find yourself in during your mid-life crisis when you desperately feel the urge to buy a silver beamer that costs three times your annual salary.
Related or Semi-related Video
Finance: What is Debt?62 Views
finance a la shmoop.. what is debt..well debt happens anytime you or anyone else
or anything else borrows money and promises to pay it back countries borrow [Hands out looking to borrow cash]
money from their citizens and from other countries
Granny borrows money from the equity in her house to pay for her full body skin [Granny getting a full body skin procedure]
lift procedure, ew! you'll probably borrow money to go to college buy a car
and buy a home credit cards are golden or plastic
tickets that let you easily borrow relatively small amounts of money to you
know buy stuff so there are tons of types of debt and to really understand [lots of examples of debt]
it all you have to think about debt from both sides of the equation that is you
as the borrower want the most flexible payback terms the cheapest interest
rates to rent that money and the least amount of grief if you're ever late on a
payment but what if you're the lender well you only have so much money to lend [woman walking and approaches a vault of cash]
and you want to maximize your returns while being smart about risk that is if
you loan 10 grand to 10 people and 9 of them pay you a fat 10% a year but one of [woman at a stand giving loans to people]
them absconds with your money to Brazil with senorita maracas well then
all your work was for nothing more or less when the interest just paid back
the lost principal on the one who absconded and yeah one bad loan can wipe
out the returns of your entire portfolio your billion bucks was supposed to produce [Man falls in water while surfboarding]
a hundred million in interest gains but when one of the ten hundred million
dollar investments died and well you ended up sitting on a billion and that's
it so no jet for you so would you loan money to your slacker friend Flaky McGee [Flaky McGee and Bill Gates together]
for the same rent as you lend to Bill Gates while Flaky McGee has a history of
you know flaking hence the name. so you'd have to take the risk of him [Flaky McGee in the kitchen with his Mom]
not paying you and you'd have to track him down in Rio or get lawyers to take
possession of the skateboard collateral he pledged for the loan and then sell it [Lawyers taking Flaky McGee's skateboard as collateral]
on eBay and hopefully get most of your money back
we'll go on record saying that you'll likely charge Flaky McGee a lot more in
interest and make the terms and conditions much more brutal than you [Terms and conditions for Flaky's loan]
would for dear old Bill well one big thing people don't seem to understand is
that debt is just about someone renting money debt does not involve ownership of
anything other than the promissory paper that contractually outlines the debt
terms the only time debt does involve ownership is when the piece of paper has [Flaky sat on a toilet]
been well you know made into toilet paper because the debtor flaked and
didn't pay back the loan that they promised to pay at that point the one
who loaned the money usually has every right to take back the collateral [Man drives car away from Flaky]
pledged behind the debt and if that collateral can't be found to break knees
you know the guys with the baseball bat remember? you ever see The Sopranos well so [Flaky screaming while on the toilet]
if you ever find yourself in that position make sure to you know hide your
knees
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