Companies have traditionally raised funds to finance their operations through a combination of debt and equity. Subordinated convertible promissory notes represent a hybrid instrument with characteristics of both debt and equity. These instruments offer companies a less expensive way to raise capital than pure equity while offering investors the opportunity to earn a higher return on their investment than investing in pure debt.
Promissory Notes
A promissory note, or note payable, is a type of debt where an in exchange for the promise of a fixed return in the form of principal and interest payments. These instruments are typically sold privately to sophisticated investors who conduct their own research on the company issuing the securities. As a potential investor, you should be on guard for fraudulent notes. These may be identified by characteristics such unusually high rates of return.
Subordinated vs. Senior Debt
A company's capital structure can be broken down into three categories: senior debt, subordinated debt and equity. Senior debt is in first-lien position. This means that in the event of default, the senior debt holders have first priority in recovering their investment. After the senior debt holders have been repaid in full, the subordinated debt holders are next in line, followed by equity holders. Given the increased risk of subordinated debt compared to senior debt, subordinated debt normally carries a higher interest rate to compensate investors.
Convertibility Feature
Some types of debt include a convertibility feature which allows the debt to be exchanged for common or preferred shares. Two characteristics of convertible debt are its conversion price and conversion ratio. The conversion price is the the price per share at which conversion occurs. The conversion ratio represents the number of shares received for each convertible debt.
Implications for Investors and Borrowers
From an investor's perspective, subordinated convertible promissory notes may offer the opportunity to convert into equity shares if the company performs well, producing an equity-like return. However, if the company's shares do not perform well, the investor's return will be tempered by the convertibility feature. From a borrower's perspective, subordinated convertible promissory notes offer the ability to raise non-senior debt while limiting interest payments, since investors are willing to accept a lower interest rate in exchange of the convertibility feature.
