Convertible notes or convertible funding can be a useful corporate funding tool for raising capital, particularly when the value of your equity is lower than you think it should be, and you can’t access the level of corporate funding you need through traditional debt.

As convertible notes are not a defined instrument under the Corporations Act or ASX Listing Rules, however, different providers offer very different terms, which can lead to a variety of outcomes for the borrower – some good, some bad and some ugly.

The best structures work to maximise the value of your equity; the worst can significantly undermine it.

Unscrupulous funders have given convertible funding a bad name in Australia, but PURE is working to change this perception, one funding partnership at a time.

In this article we cover the typical features of convertible notes, the pitfalls to watch out for, and we demonstrate why we believe PURE’s offering compares favourably not just to other forms of convertible funding, but equity in general.

What is convertible funding (aka convertible notes)?

Convertible notes or convertible funding is a loan of capital from an investor to a company that has the option to convert to equity at some point in the future. All convertible note-type structures therefore consist of two elements: a loan, and an option to purchase equity.

In a traditional convertible note structure, these two elements are combined into a single instrument, the terms of which are set in a convertible note deed. When the loan converts to equity no additional capital changes hands, the debt to the lender is extinguished and shares are issued at the agreed valuation.

In alternative convertible note structures, such as offered by PURE, the loan and equity option are separated out into individual instruments, which benefits the borrower through being able to repay the loan at any time, and the lender through retaining the option to purchase equity after the loan has been repaid.

When to consider convertible funding and why

While the stock market is an efficient clearing mechanism for realising the intrinsic value of a share in a company over time, companies often experience instances of temporary price dislocation where the punishment (a drop in share price) exceeds the crime (e.g. missing forecasts, only to get back on track over the next 12 months).

When such dislocations coincide with the need to raise capital, particularly for growth initiatives, the dilution can be costly to existing shareholders.

In such instances, a convertible note with reasonable tenure (2-4 years) can look through the short-term issues temporarily suppressing equity price performance, and give the company the ability to raise capital closer to its intrinsic value, thereby minimising permanent EPS dilution for shareholders relative to a discounted equity raise.

Consider the following example:

ASX aspirant Super Growth Corp Pty Ltd lists on the ASX at a $100 million valuation, forecasting prospectus NPAT of $10 million, and raising $20 million of new equity at $100 per share. The capital is required to build a new factory to meet strong order growth.

Due to unforeseen delays in finalising construction of the factory, however, the extra manufacturing capacity comes online six months late, deferring $5 million of the forecast NPAT into the subsequent financial year. What happens? The equity value of the Company halves to $50 million (we’ve all seen it or lived it!).

But while the construction of the factory has been delayed the Company’s order book has continued to grow, and now the company requires an additional $20 million in capital to fund component purchases and create more finished goods.

The Company has two options to access this capital: complete an equity raise at a discount to the prevailing share price (50% below IPO), suffering EPS dilution despite guaranteed profit growth due to the new orders; or the Company can raise capital closer to its intrinsic value via a convertible note.

See below the relative EPS outcomes:

As can be seen in the above table, provided the company can afford the temporary cash flow cost of the coupon on the convertible note (assuming the coupon is struck as cash – it could be capitalised or paid in shares – discussed further below), the convertible funding structure results in 49% fewer shares being issued to provide corporate funding, leaving more profit in shareholders’ hands.

It also gives the company the opportunity to realise an equity value on conversion much closer to the original IPO price of $100 per share – $87.50 per share in the above example, versus $45.00 via the equity raise.

Examined through a different lens, to leave the same level of profit in shareholders’ hands having gone down the route of a discounted equity raise, the Company would need to find a way to generate 17.6% more profit after tax than currently expected, to deliver the same profit per share to existing shareholders.

When else might a company consider convertible funding?

Convertible funding or convertible notes can also be a useful tool to obtain capital when it is difficult to determine a fair current equity value for a company. This most often applies to companies that are growing quickly and are private, ie. do not have a traded market price.

Convertible funding structures enable a company to raise capital today that converts at a discount to a future valuation, determined by subsequent liquidity event such as trade sale or IPO. In such instances the convertible funding provider will often seek a cap on the conversion valuation, so as to ensure a reasonable return can be realised for the time and risk exposure.

Finally, convertible funding can be a useful tool for securing additional capital when debt funding is unavailable, or when the level of debt funding available does not match the overall company’s funding requirements. The benefit of convertible funding over straight debt is the company has a built-in mechanism for repaying the loan (ie. conversion).

Features of convertible notes or convertible funding

Convertible notes or convertible funding are not defined instruments under the Corporations Act or ASX Listing Rules, and therefore the features of a given note can vary from provider to provider.

That said there are features that are common to most notes. We explore these and the consideration you should give to each as borrower in the following table.

Common pitfalls of convertible note structures

If you don’t live and breathe structured finance, understanding how the interrelated components of a convertible funding offer can play out under a range of different share prices, conversion windows and quantums of funding can be challenging.

Convertible funding providers know this and unfortunately many base their business models on it, seeking to take advantage of their borrower’s lack of understanding.

Whilst you should always engage a good legal counsel versed in convertible funding to review your specific facility, the common areas where companies come unstuck are not capping the number of shares that are issued on conversion, not fixing the conversion price, and leaving themselves open to liquidity traps.

What does that all mean?

Convertible funding that does not fix the number of shares that the instrument converts into leaves existing equity investors open to uncapped dilution. A $5 million convertible note facility that converts at $1 per share results in 5 million new shares on issue; a $5 million convertible note facility that converts at $0.10 per share results in 50 million new shares on issue – you get the idea.

Although the ASX has taken steps to tighten rules around floating conversion ratios, there are still ways to realise such structures.

On face value, leaving the number of shares the facility can convert into as a function of the conversion price is attractive – after all, the higher the share price at the time of conversion, the lower the number of shares to be issued.

The problem is this also works the other way, ie. the lower the share price at conversion, the higher the number of shares that are issued. And it is often the latter situation that eventuates, as funding providers that favour this structure have a couple of tricks up their sleeve.

Generally, corporate funding providers lending under variable conversion volume or price structures are looking to lend to companies with illiquid trading, and/or where they can obtain reasonable borrow in the stock to be able to sell short.

Funders in these scenarios typically ask for any fees associated with the facility to be paid in stock, or request an ongoing proportion of the interest to be paid in stock. This stock is then used to sell into the market and depress the share price. When a company’s shares are traded infrequently, this is relatively easy to do.

It can also become a vicious circle, as the selling initiated by the funder spooks other equity investors, who then begin to sell as well. One such structure that we refinanced for an ASX-listed company, took just three months to depress the share price  by 45%, despite no announcements to the market about the company’s underlying fundamentals.

Some funders offer to cap how much they can transact in a stock in any given month at a percent of daily volume, or similar. On face value this appears to neutralise the risk of the funder being able to suppress the share price, but if the stock is illiquid enough it doesn’t matter.

Further, they have ways of circumnavigating this cap, such as inviting a second funder to fund 50% of the transaction, so they each have their own individual volume cap. What the borrower doesn’t always appreciate at the time is these parties can subsequently act in concert to sell, so individual volume caps of, say, 20% of daily volume, combine to total 40%.

The lesson? Avoid convertible funding structures where you can’t fix the number of conversion shares, fix the price, or are required to pay fees in, or give away, shares.

Existing shareholder considerations

Convertible notes or convertible funding is attractive for its ability to reduce dilution, when it enables a company to raise capital through a loan that converts to equity above its share price at facility inception.

This is contrary to raising capital through a placement or rights issue, which in almost every instance happens at a discount to the prevailing share price.

Whilst raising equity capital at a discount to the prevailing share price can be frustrating for boards and management teams, particularly when the capital is funding an EPS-accretive initiative, equity investors love it as they’re all but guaranteed positive portfolio attribution for the position in the month the capital is raised.

Naturally, this sets the goals of using convertible funding – minimising the number of shares on issue – at odds with the goals of many (but not all) equity investors. So, expect to potentially ruffle some feathers in doing a convertible structure over a straight equity raise.

The arguments for pursuing convertible funding instead of an equity raise are generally:

• the company is unhappy with its cost of equity and equity investors aren’t willing to price in some of the EPS accretion from the transaction to be funded, through bidding for stock above-market
• the capital being raised will fund an EPS-accretive initiative, and therefore raising capital below the current share price to fund it does not make sense
• the company is unlikely to be able to access all of the capital it requires through a rights issue
• a placement to new investors would dilute non-participating existing investors more than a convertible note
• the convertible note can raise all of the capital needed from a single investor, significantly reducing ‘herding-of-cats’ headaches
• the convertible funding provider can be wall-crossed more substantially, enabling them to price the company’s cost of capital more keenly.

Remember, it’s about running the most efficient capital structure for all investors – it’s not about trying to please everyone all the time which is, of course, impossible.

When convertible funding expires unconverted

Occasionally, despite best efforts and intentions, a company’s share price will not move into-the-money for the convertible facility to be able to convert to equity prior to expiry.

As custodians of third-party capital, the convertible funding provider cannot convert out-of-the-money (and thereby knowingly destroy investor value), but if you’re working with the right provider, there are generally several options open to you to resolve the situation.

i) If the convertible has or is expiring out-of-the-money and the debt becomes or is expected to become repayable, you might first consider how far out of the money the note is. After all, the note was originally issued to avoid an equity raise at the prevailing share price. If the note is expiring just out-of-the-money, you may now be sufficiently happy with your cost of equity capital to go ahead and raise equity to repay the note.

ii) the right convertible funding provider will be open to negotiating a mutually beneficial outcome with you. This could include such options as:

• extending the term of the facility
• changing other terms of the facility
• amortising capital repayment if the facility was originally constructed as a bullet payment at term
• converting some of the facility to equity on new terms

Or other alternatives. You will need to provide an incentive for the note holder to alter terms, such as offering to change the interest rate, issuing an options package as compensation for the increased risk the facility provide is taking, or offering to repay a larger amount in return for the term being extended.

The key here is to approach the situation early, transparently, and with a commercial hat on. If you’ve partnered with the right convertible funding partner, they will not want to ‘loan to own’, preferring instead to reach agreement on a suitable work around with you.

PURE vs other Convertible Note Providers

PURE has intentionally set about creating a company-friendly convertible funding offer with standardised terms and clear alignment with maximising equity price performance.

Compare PURE’s offering versus typical convertible note offerings in the following table.

Need capital? Contact the PURE team here for a confidential discussion.