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.