Why do Investors ask for Convertible Debentures?

Why do investors ask for convertible debentures?

Introduction

Let’s begin by understanding what are convertible debentures. A convertible debenture is a kind of long-term debt which can be transformed into stock after a specific period of time. A convertible note or debenture is usually an unsecured bond or a loan as in there is no primary collateral interlinked to the debt.

These are long-term debt securities that pay interest returns to the bondholder. A unique feature of convertible debentures is that they can be converted into stock at specified times. It gives the bondholder some security that may put down some of the risks involved with investing in unsecured debt.

A convertible debenture can be transformed into equity shares after a specific period. The option of converting debentures into equity shares lies with the holder. A convertible debenture will provide regular interest income via coupon payments and repayment of the principal amount at maturity.

What does the Companies Act, 2013 say about convertible debentures?

Section 2(30) of the Companies Act, 2013 (“the Act’) defines a ‘debenture’ to include debenture stock, bonds or any other instrument of a company evidencing a debt, whether constituting a charge on the assets of the company or not. That is, a debenture is a debt instrument for the company.

Section 71 of the Act lays down the conditions attached to debentures. The relevant part reads as under:

“(1) A company may issue debentures with an option to convert such debentures into shares, either wholly or partly at the time of redemption:

Provided that the issue of debentures with an option to convert such debentures into shares, wholly or partly, shall be approved by a special resolution passed at a general meeting.

(2) No company shall issue any debentures carrying any voting rights….”

However, no company can issue convertible debentures without passing a special resolution.

Why do Companies issue Compulsory Convertible Debentures?

The companies usually prefer issuing CCDs due to the convenience and flexibility associated with them. These convertible debentures act as a great fund-raising alternative especially for start-ups planning to raise money at the initial stages in order to expand or maintain their business.

Also, the market driven valuation of the new company can be pushed to a later date since there is no urgency to fix its valuation straight away.

Types of Convertible Debentures

1. Fully Convertible: These are debentures in which the whole value of debentures can be converted into equity shares of the company.
2. Partly Convertible: In this kind of debentures, only a part of the debentures will be eligible for conversion into equity shares.

Features of fully and partly convertible debentures

Parameters	Fully Convertible Debentures	Partly Convertible Debentures
Definition	The value can be changed into the company’s equity shares.	Only some portion of the debentures would convert to company’s equity shares.
Flexibility in terms of financing	They have a highly favourable debt-equity ratio.	They have a favourable debt-equity ratio.
Classification for calculation	They are classified as equity.	The convertible portion is classified as equity, whereas, the non-convertible part is classified as debt.
Suitability	Fully convertible debentures are suitable for companies which do not have an established track record.	Partly convertible debentures are suitable for those companies that have an established track record.
Popularity	They are highly popular among investors.	They are not very popular among investors.

Benefits of issuing convertible debentures

For an investor the benefits from asking for convertible debentures are as follows –

The most popular benefits of convertible debentures for investors are as follows –

• Investors receive a fixed-rate of interest on a continued basis and also have the option to partake in stock price appraisal.
• In case the company’s share price declines, investors are entitled to hold onto the bonds until maturity.
• Convertible debenture holders are paid before other shareholders in the event of liquidation of the company.
• Being a hybrid investment instrument, investors are entitled to fixed interest payouts and also have the option of converting their loan to equity when the company is performing well or when its stock prices are rising.
• As per the Companies (Acceptance of Deposits) Rules, 2014 which does not include clause xi of Rule 2 (1) (c) can raise the amount of issuance of debentures as referred in Schedule III of the Act which also not include the insubstantial assets of the debentures compulsorily convertible into a equity share capital of the company within a period of 10 years. So it is compulsory for the compulsorily convertible debenture into an equity share capital within a period of 10 years otherwise it will be viewed as deposit under the Companies Act, 2013 and the provision of ‘deposit’ will be taken into consideration. With the amendment made in the year 2016, the time period has increased from 5 years to 10 years.

Some other benefits available to the company are –

• Tax deductible on interest payments - Interest on convertible debentures is allowable as a tax deduction to the Indian Company thereby resulting in an effective tax saving of 30% (subject to the availability of sufficient profits).
• Tax on conversion of convertible debentures - Conversion of compulsorily convertible debentures into equity shares is not liable to tax in India.
• Conversion ratio - Under the existing regulations, the ratio of conversion of convertible debentures into equity shares/price of conversion, has to be specified upfront at the time of issue of such CCD. Generally, the period for which CCD can be issued is 8-20 years.

Conclusion

Convertible debentures can prove to be quite profitable for both the company issuing it and the investors buying it.

As far as investors are concerned, convertible debentures are an ideal choice for those investors who wish to invest and get the benefits from both debt and equity instruments at different times.

Convertible debentures tend to provide a security cushion for investors who wish to be participants in the growth of a particular company but are unsure of its prospects. By investing in convertibles, an investor is putting a limit to their downside risk at the expense of limiting their upside potential.

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