A compulsory convertible debenture (CCD) is a form of debenture that must be converted into shares by a certain date.
A debenture is a debt security issued by a company in order to borrow money at a fixed interest rate over the medium to long term. Unlike the majority of investment-grade corporate bonds, it is not collateralized. It is supported solely by the issuer’s complete faith and credit.
There are two types of debentures: non-convertible and convertible.
NonConvertible Debenture is a fixed-term financial instrument issued by corporations in order to generate resources/capital via public or private placement.
A convertible debenture is a type of long-term debt issued by a corporation that, following a specified period, can be converted into shares of equity stock.
Advantages of Compulsory Convertible Debentures?
Now, let’s have a look at the various benefits associated with these convertible debentures:
- A Secured Debt:
Due to the fact that CCDs will convert into equity shares in the future, they appear to be an attractive option. The investor’s perception that the conversion of CCDs is correlated with the company’s performance bolsters its suitability as a secured debt investment. This motivates an increasing number of investors to invest in this lucrative investment option.
- Clear Terms & Conditions:
The terms and conditions of a Compulsory Convertible Debenture are determined in advance, prior to their issuance. Also determined at the time of issuance is the price/conversion formula for CCDs. This increases the system’s transparency and makes it a dependable investment option for the long term.
- Pricing and Discount benefit:
Usually, a discount is applied to a Compulsory Convertible Debenture because the investor is investing in the company at a very early stage. The company valuation can be determined at a later time without any difficulty. This is a significant breath of relief for the company prior to the valuation of the subsequent investment round.
- Lower Rate of Interest:
In comparison to Non-Convertible Debentures (NCD), the company can pay a reduced rate of interest when it issues CCDs at a discount. However, investors are prepared to accept a lower rate of interest on these convertible debentures due to the ease with which they can be converted into a company ownership stake in the future. From the perspective of the company, CCDs aid in capturing the tax benefit on interest paid to the CCD holder.
- Investor’s Right to Preferential Payment:
CCD is a debt instrument as long as it is converted into equity shares. This means as a holder of a CCD, you have a payment preference over other company stakeholders.
Drawbacks of Compulsory Convertible Debentures?
Investors should be aware of the following drawbacks of compulsory convertible debentures:
- Due to the lower interest rate accrual, convertible debentures may present disadvantages to investors when compared to traditional bonds.
- There is a risk of company default in which the company may not even pay its debenture holders the principal amount.
- There is a possibility that a company’s stock price will decline after conversion. In this scenario, investors may lose their entire investment.
What are the reasons companies issues CCDs:
Companies normally favor issuing CCDs due to the convenience and adaptability they offer. These convertible debentures are an excellent option for startups seeking to raise capital in their early phases in order to expand or maintain their business.
In addition, the market-based valuation of the new company can be delayed as there is no immediate need to determine its value.
How are CCDs traded:
CCDs are normally considered as equity, but their structure is more similar to debt. The investor may have a put option that requires the issuer to purchase back shares at a fixed price.
In contrast to pure debt issues, such as corporate bonds, compulsory convertible debentures pose no credit risk to the issuing company because they eventually convert into equity. CCDs also alleviate some of the downward pressure that a pure equity issuance would have on the underlying stock because they are not promptly converted into shares.
Conclusion:
A Compulsory Convertible Debenture is a common term in the established as well as the emerging start-up ecosystem. Due to its extensive adaptability, it earned a significant amount of popularity. In addition, there is no immediate dilution in the company’s capitalization table, which is delayed until the conversion of CCDs.
Nonetheless, these convertible debentures necessitate routine compliance work on the part of the issuing company. Nonetheless, the vast majority of benefits offered by this hybrid instrument are numerous and cannot be disregarded. Moreover, these convertible debentures are an effective means of attracting Foreign Direct Investment into the country.
As long as these Compulsory Convertible Debentures meet the investor’s long-term financial objectives, they can be viewed as an attractive investment.
