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Convertible debt a good deal for lenders,
but a last resort for cash-starved firms

The perils of convertible debtOne minute it's debt, the next it's an equity investment. That's the changeling nature of convertible debt, a bit of financial legerdemain that small-business owners may want to tuck up their sleeves as a last-resort move.

"Generically, it's debt that is convertible to equity," explains George Shea, president of the Ambassador Capital Corporation, an Atlanta-based investment banking firm that works with high-technology companies.

Use it to sweeten the deal
Convertible debt often is used as a deal-sweetener -- the clincher that convinces a lender to finance a fledgling company. With convertible debt, a lender has a big upside: If the company takes off, the lender can opt for stock in a fast-growing company. Or, the lender can stick with the original loan setup and get its money back plus interest.

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"Susie, a private investor, doesn't know you and whether your company will succeed or not. Convertible debt is basically a hedge for backers like Susie," Shea says. "She gets the advantage of converting the loan into stock and, if your company succeeds, she may have a strong preference for that."

Michael Troy, founder and president of KnowledgePoint, has used it twice to get financing for his human resource software company in Petaluma, Calif.

"My attorney suggested it to me and went in that direction," Troy recalls. "I wanted to have a clear exit strategy for my investors ... This way, I could say, 'Here's how you'll get your money back -- with a loan that gets paid back with the option to convert it to stock. It gave them a clear path to liquidity.' "

The first time he used convertible debt was in 1985. He gave eight lenders the option to convert in exchange for $76,000. Under their agreement, the investors received a quarterly guaranteed interest rate payment (5 percent above prime, capped at 15 percent) and could exchange their loan for an equity stake anytime after November 1988 but before the last six months of the five-year loan. Half the investors chose to convert their loan repayment into stock.

Troy used the same mechanism 10 years later to raise $500,000. While those loans are still outstanding, he expects all the investors to convert to equity.

Why it's a last resort
While convertible debt can bring in the money, it has several important minuses.

It can be complicated to arrange and administer. It can be done, but it takes a lot of work and probably should only be used as a last resort.

It can be much more costly: Not only are you paying interest, but you may be giving up a chunk of your business. For that reason, Shea suggests that a small-business owner using convertible debt should hold out for an interest rate that's only a couple of points above prime.

Finally, convertible debt can turn off future lenders. Troy says his original convertible debt deal made KnowledgePoint debt heavy and unappetizing to bankers. The company wasn't able to get a bank loan until 1991 -- when half its debt holders converted their debt to equity.

The experts' advice
Experts give the following advice on how to make convertible debt work for your company:

  • Work closely with your lawyer to make sure the conversion agreement (under what conditions and when debt can be converted to stock) is a good one. For example, make sure you have as much control as possible over the conversion process. "I think the challenge is to do what's legally appropriate and you need to have a good attorney involved," Troy says.
  • Spend adequate time on valuation; that is, what price will be set for the stock. Ask your accountant for assistance. Make sure your CPA has experience in such dealings and has a good understanding of IRS regulations.
  • Try to use the conversion as leverage with your lenders, for example, to negotiate a lower interest rate or to get an investor, who would otherwise walk away, to commit.

Follow that advice and your company's convertible debt plan won't just be financial mumbo jumbo, but will deliver for you and your backers.

"Even with all the venture capital money that's around, not every business can get venture capital," Troy says. "This is an option that falls below the radar scope of venture capital and can help companies that can't get backing through more traditional means."

Jenny C. McCune is a contributing editor based in Montana
To comment on this story, please e-mail the
Bankrate.com editors

-- Posted: July 6, 2000

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