A “convertible security” is a security – typically a bond or a preferred stock – that can be converted into a different security – usually shares of the company’s common stock. In most cases, the holder of the convertible securities determines whether and when a conversion occurs. In other cases, the company may retain the right to determine when the conversion occurs. ISIN Network can help your company determine if and when to offer convertible securities.
Companies generally issue convertible securities to raise funding (often via private placement). Companies that have access to conventional means of raising capital (such as public offerings and bank financings and more) might offer convertible securities, like bonds or preferred stock, for particular business reasons. Companies that may be unable to access conventional financing sources of funding sometimes offer convertible securities as a way to raise money more quickly. In a conventional convertible securities financing, the conversion formula is generally fixed – i.e. the convertible securities converts into common stock based on a fixed price. The convertible securities financing arrangements might also include caps or other provisions to limit dilution (the reduction in earnings per share and proportional ownership that occurs when, for example, holders of convertible securities convert those securities into common stock).
By contrast, in less conventional convertible security financings, the conversion ratio may be based on fluctuating market prices to determine the number of shares of common stock to be issued on conversion. A market price based conversion formula protects the holders of the convertibles against price declines, while subjecting both the company and the holders of its common stock to certain risks. Because a market price based conversion formula can lead to dramatic stock price reductions and corresponding negative effects on both the company and its shareholders, convertible security financings with market price based conversion ratios have colloquially been called “floorless”, “toxic,” “death spiral,” and “ratchet” convertibles.
Both investors and companies should understand that market price based convertible security deals can affect the company and possibly lower the value of its securities. Here’s how these deals tend to work and the risks they pose:
The company issues convertible securities that allow the holders to convert their securities to common stock at a discount to the market price at the time of conversion. That means that the lower the stock price, the more shares the company must issue on conversion.
The more shares the company issues on conversion, the greater the dilution to the company’s shareholders will be. The company will have more shares outstanding after the conversion, revenues per share will be lower, and individual investors will own proportionally less of the company. While dilution can occur with either fixed or market price based conversion formulas, the risk of potential adverse effects increases with a market price based conversion formula.
The greater the dilution, the greater the potential that the stock price per share will fall. The more the stock price falls, the greater the number of shares the company may have to issue in future conversions and the harder it might be for the company to obtain other financing.
Before one decides to invest in a company, determining what types of financings the company has previously engaged in – including convertible security deals – is important. It is important to understand the effects those financings might have on the company and the value of its securities.
Often times you can find this out by accessing and researching the company in the SEC’s EDGAR database and looking at the company’s registration statements and other filings. Even if the company sells convertible securities in a private, unregistered transaction (or “private placement”), the company and the purchaser normally agree that the company will register the underlying common stock for the purchaser’s resale prior to conversion. One can also find disclosures about these and other financings in the company’s annual and quarterly reports on Forms 10-K and 10-Q, respectively, and in any interim reports on Form 8-K that announce the financing transaction. Knowing what financings the company undertook can help one determine if one should even invest, as well as help in his/her negotiations with the company.
If the company has engaged in convertible security financings, it is best to ascertain the nature of the convertible financing arrangement – fixed versus market price based conversion ratios. Ensure that you and your team fully understand the terms of the convertible security financing arrangement, including the circumstances of its issuance and how the conversion formula works. One should also understand the risks and the possible effects on the company and its outstanding securities arising from the below market price conversions and potentially significant additional share issuances and sales, including dilution to shareholders. Be aware of the risks arising from the effects of the purchasers and other parties trading strategies, such as short selling activities, on the market price for the company’s securities, which may affect the amount of shares issued on future conversions.
Companies should also understand the terms and risks of convertible security arrangements so that they can appropriately evaluate the issues that arise. Companies entering into these types of convertible securities transactions should understand fully the effects that the market price based conversion ratio may have on the company and the market for its securities. Companies should also consider the effect that significant share issuances and below market conversions have on a company’s ability to obtain other financing.
Companies or investors seeking to learn more about the SEC’s registration requirements for common stock issuable upon conversion of unregistered convertible securities, including the timing of the filing of the resale registration statement and the appropriate form that the company may use to register the resale, should consult the Division of Corporation Finance’s Compliance and Disclosure Interpretations (of the SEC), or contact ISIN Network. (Some information taken from www.sec.gov/answers/convertibles.htm)
ISIN Network can help your company determine if and when to offer convertible securities.
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