Convertible debenture basics: How investors and companies can benefit according to the law

Simply a loan with a twist; a convertible debenture gives investors the option to convert debt into a stake in a company. For those looking to invest or raise money, this type of offering can open new doors, not just for the business owners, but also for debenture holders.

In this article, we’ll be covering the essentials of convertible debenture. In any case, there’s no substitute for the legal advice of corporate finance lawyers if you want to know more about this type of investment deal.

What is a convertible debenture?

A convertible debenture is a type of loan that a company issues to raise capital for its business. It works like a regular loan at first, where the company pays interest to the person or group who buys the debenture.

Adam Bata, a partner at the corporate/M&A group of Miller Thomson LLP, gave some insights : “A convertible debenture is a debt instrument that includes a feature requiring (or, in some cases, permitting) the lender to convert the debt into equity of the issuing company on certain triggering events.”

He cites some examples of these triggering events:

• a subsequent equity financing of the issuing company
• the maturity date of the debt
• a sale transaction or an initial public offering

“A high-growth company may want to issue a convertible debenture to an investor instead of shares in order to delay locking in a share valuation until a future larger financing round or sale transaction,” Bata adds.

But why do investors engage in convertible debentures? Bata explains that “[a]n investor may want to purchase a convertible debenture to have the benefit of interest accruing until such time as the debenture converts to equity on a future financing round or sale transaction, typically at a discount to that transaction price.”

Watch this video explaining what convertible notes and SAFEs are and how they are related to convertible debentures:

To learn more about these investment instruments, reach out to the best corporate finance lawyers in Canada as ranked by Lexpert.

Overview of convertible debentures

What makes convertible debenture unique is that its holder can choose to:

• convert this loan into shares of stock of the company after a set period or under the agreement’s conditions
• receive the principal back, plus a certain interest on top of the capital, after its maturity or a certain period

This option is usually written into the agreement when the debenture is first offered. The first option makes convertible debentures, well, convertible. In other words, instead of a loan, it is now converted into shares of stock.

Convertible debentures are not backed by company assets. If the company goes out of business, debenture holders are paid only after secured creditors.

Many investors choose convertible debentures because they offer holders a chance to become shareholders if the business goes well. For instance:

• if the company’s stock price increases, the holder can convert the loan into shares, to benefit from the growth
• if not, the holder continues to receive interest and get the principal back at maturity

Companies use convertible debentures to raise capital at a lower interest rate than regular loans. This is because the conversion feature is valuable to investors. However, if many holders decide to convert their debentures into shares, existing shareholders may experience dilution.

How does convertible debenture work in Canada?

Convertible debentures are loans that can be converted into company shares. They allow investors to earn interest or become shareholders, depending on the company’s performance and the terms of the agreement.

Bata gives a timeline of how convertible debenture work:

1. Once a letter of intent or term sheet is agreed upon between an investor and the issuing company, convertible debenture financing typically involves negotiating a loan or debenture purchase agreement and a convertible debenture document.
2. The loan agreement generally contains:
   1. details of the loan
   2. use of funds
   3. representations and warranties
   4. closing conditions
3. The convertible debenture will include details with respect to:
   1. interest accrual
   2. maturity and conversion triggers
   3. discounts
   4. mechanics
4. As part of the closing process, the investor completes business and legal due diligence, and the parties finalize ancillary documents, including:
   1. corporate authorizing resolutions
   2. certificates confirming compliance with securities laws
   3. documentation of the closing flow of funds

Below are some of the features of this type of public offering and how they usually work:

Key features of convertible debenture

Some features set convertible debentures apart from other loans and investments, though they can function similarly to other capital-raising instruments.

Here are some of the key features of a convertible debenture:

• interest payments: the company pays regular interest to the debenture holder until the debenture is converted or when it matures
• fixed terms: as a contract, the agreement will set out the interest rate, the conversion price, and the maturity date of the debt
• lower interest rates: because the conversion feature is valuable to investors, companies usually offer lower interest rates on convertible debentures
• conversion option: the set period or the specific conditions that will allow the holder to convert the debenture into company shares are set in the agreement
• potential for equity upside: one of its most attractive features is that debenture holders can benefit from a rise in the company’s share price if they choose to convert it into shares

Whether you’re a startup raising capital or an investor considering convertible debentures, these features can help determine if this option fits your needs.

Canadian laws governing debentures

The laws of Canada, both federal and provincial, apply to investment agreements, such as convertible debenture in the following ways:

• corporation laws: the Canada Business Corporations Act and provincial laws govern the corporation that issues the debentures
• laws on securities: the relevant provincial and territorial securities law govern the process of issuing investments (e.g., prospectus requirement)

Convertible debentures vs. other debt instruments

To meet the needs of various investors, companies offer a range of financial and debt instruments. We listed some of these instruments, which can be used by startups and corporations in raising capital and may be compared to convertible debentures:

• non-convertible debentures: aside from not having the “convertible” feature, these can be secured or unsecured, depending on the agreement; they also have higher interest rates compared to convertible debentures
• Simple Agreement for Future Equity (SAFEs): unlike convertible debentures, SAFEs are not loans and do not earn interest; instead, SAFEs are converted to shares in the next financing rounds depending on the investment agreement

Advantages and disadvantages of convertible debenture

A convertible debenture can offer several pros and cons for both companies and investors, including:

Advantages

• for companies:
• raising funds at a lower interest rate compared to regular loans, providing more capital for operations
• startups and early-stage companies can use a debenture to raise money without setting a company valuation right away
• for investors:
• investors can benefit whether the company is performing well or not
• a rise in the company’s share price is beneficial if investors convert their debentures into shares
• but if the company’s shares are not performing well, investors will receive regular interest payments and can get their principal back at maturity

These features make convertible debentures a flexible tool for raising capital and managing risk. Here’s another video explaining the advantages:

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Disadvantages

• unsecured debt: convertible debentures are not backed by company assets; still, holders can be paid after the secured creditors if the company goes insolvent or bankrupt
• dilution risk: if several holders convert their debentures, either at the same time or over the years, the company’s original shareholders end up owning smaller shares of the company

Examples of convertible debentures in Canada

Here are a few of the largest convertible debenture deals handled by Canadian law firms in the past few years:

• H&R Real Estate Investment Trust (H&R REIT) made a public offering in 2017 of $125 million principal amount of 2.9 percent unsecured debentures, due in 2022
• in 2016, Kelt Exploration Ltd. reported it had finished selling $75 million in 5 percent convertible subordinated unsecured debentures
• Primero Mining Corp. closed its offering in 2015 of US$75 million aggregate principal amount of 5.75 percent convertible subordinated debentures, due in 2020

How can lawyers help businesses or investors with convertible debentures?

One can be lost and simply overwhelmed with all those numbers flying around investments, stocks, and convertible debentures. To dispel any confusion, corporate finance lawyers are there to help in one way or another.

Here are some matters you can talk to your lawyer about when it comes to debentures, according to Bata:

• Structuring the deal: Lawyers assist investors or issuing companies with convertible debenture financings by structuring key deal terms—such as interest, discounts, valuation caps, conversion triggers, and maturity—to align with business goals, drafting and reviewing essential legal documents, and ensuring compliance with Canadian corporate and securities laws.
• Help with negotiations: They also help manage risk by negotiating investor protections, completing due diligence, and safeguarding the client’s position during conversion or default. Knowledgeable counsel can help startups secure funding (or investors invest) efficiently while minimizing legal exposure.

In summary, a lawyer’s advice can help all parties of an investment deal to avoid surprises and understand the implications of a convertible debenture.

Convertible debenture: Making the most out of debts

A convertible debenture can offer flexibility for companies and investors. It allows businesses to raise capital at a lower cost and gives investors the option to become shareholders. However, it is important to consider both the benefits and risks.

Before making any decisions, it helps to talk to a legal professional who understands Canadian finance law. A corporate finance lawyer can explain the finer details and help you decide if a convertible debenture is right for you.

By getting the right legal counsel, company owners and potential investors can understand these agreements and make informed decisions.

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