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What is a Convertible Note?

Osmand Vitez
Osmand Vitez

A convertible note is an investment that an investor can exchange for stock at some point in the future. Most convertible instruments start out as corporate bonds issued by an organization. The bonds have a low interest rate, as the company will not desire high interest rates for future payouts prior to the exchange for the instrument into stock. Domestic and international investors can take advantage of these investments. Investment markets from the United States, Japan, Canada, Europe and Asia and have a wide offering of convertible note instruments investors can buy in hope of a future stock exchange.

Although these investment instruments sound very enticing, they do have some disadvantages in addition to their advantages. The first advantage for the company is the ability to offer low interest rates on the bonds. Investors purchase these investments based on the hope for a future stock exchange, not a planned date of exchange. The company can therefore engage in debt financing with low interest payments on the debt. This increase the return on investment for the convertible note instruments sold. Other investors and reviewers of the company will see this return as a good thing as the bonds will not weigh too heavily on the company’s profits, assets or other financial information.

Man climbing a rope
Man climbing a rope

Another advantage is the ability to instantly wipe away debt from the company’s accounting books. High debt listed on the company’s balance sheet is never good. Through the sale of convertible notes, however, the company can convert a large chuck of bonds to stock and the debt will go away with the stroke of an accountant’s pencil. While the company will have to make a disclosure on the financial statements to explain this transaction to all investors, the conversion allows for the debt reduction from a convertible note transaction to take away less value form the company’s assets.

A significant disadvantage to the conversion of convertible note instruments to stock is the dilution of current shareholder value. All shareholders — from individual investors to financial institutions — will have their total investment value drop as more shares of stock enter the market from the convertible notes. Current shareholders will often dislike the notion of losing value through this conversion. One way investors can mitigate this loss of value is to purchase a portion of the convertible bonds offered by the company. When the conversion occurs, the total share value should have less negative effects from the convertible bonds to common stock exchange.

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