A debenture is a long-term financing instrument used primarily by companies that have a steady source of income. In the last few years, this type of financing has regularly been used for start-ups, which need to secure funds to accelerate their growth.
Corporations and governments frequently issue debentures to raise capital and develop new projects. In the last decade, the Canadian convertible debenture market has experienced strong growth. However, little is known about the risks associated with this type of financing.
What Is a Debenture?
A debenture is an unsecured debt security issued by a corporation or government and secured only by the creditworthiness and reputation of the issuer, not by a guarantee.
It is agreed upon in the form of a contract between the issuer (debenture applicant) and the investor.
The debenture, also known as an unsecured bond, is recorded as a debt on the balance sheet of the issuing company.
Its main purpose is to increase a company’s funds to support its development and management of its long-term financial activities. Typically, debentures are issued by large companies with AAA credit scores, but more and more start-ups are accessing this type of debt to finance their growth.
Difference Between Convertible and Non-Convertible Debentures
Convertible or exchangeable debentures are bonds that can be converted into equity shares of the issuing company after a specified period. Convertible debentures are hybrid financial products that offer both debt and equity benefits.
Companies use debentures as loans by paying fixed interest. However, debenture holders have the option of holding the loan until maturity and receiving the interest payments or converting the loan into equity shares.
Convertible debentures are increasingly used in Canada. Today, the convertible debenture market exceeds $14 billion (Source).
Non-convertible debentures are common debentures that cannot be converted into equity of the issuing company. The investor faces more risk if the debenture is non-convertible, as he cannot benefit from the equity generated by the conversion.
In order to offer a product that respects the risk/reward relationship, the interest rate will be higher under the non-convertible debenture and therefore allows the investor an additional return.
Debenture vs. Obligation
A debenture is a form of bond, but it is not secured by specific assets. Bonds are common forms of debt for large public companies, municipalities and governments and are generally considered a more secure investment than debentures because the risk of default by the issuing company is lower. We generally don’t see as much bond financing in the financing package of start-up companies.
In the case of a bond, the maturity varies between 1 year and 30 years and the expected return comes from two factors:
- Interest payments
- Difference between the sale price of the bond and the price paid for the bond
If the issuing company is dissolved, the holder is entitled to a portion of the remaining assets of the company (priority over the shareholders).
Features of a Debenture
A verbal promise to acknowledge a debt is not a debenture. A trust deed must first be drafted. The trust is an agreement between the issuing company and the trustee who manages the investors’ interests.
The coupon rate is the interest rate that the issuing company pays periodically to the debenture holder or investor. This rate can be fixed or floating. A higher rate implies riskier debt securities and a lower rate means less risky debt securities. The coupon rate also depends on whether the debenture is convertible or not.
Credit score is an important indicator of the creditworthiness of the issuing company. Following the investment, an improvement in the credit quality of the issuing company is good news, as it decreases the probability of default on future payments, whereas a deterioration in credit quality increases the probability of default.
The maturity date is the date when the company must repay the debenture holders. There are various alternatives for repayment. The most common is a principal redemption where the issuer pays a lump sum at the maturity of the debt.
How Debentures Work
The debenture provided by the borrower represents a bilateral contract including the characteristics of the financial instrument such as the loan amount, convertibility, interest rate and maturity date.
After signing the contract, the investor lends the funds to the debenture applicant. In return, the issuer is expected to make periodic repayments based on the interest rate specified in the contract.
Example of a Debenture: Goodfood Market
Since private companies don’t really provide financial information, here is an example of a Canadian public company that recently raised convertible debenture financing.
In February 2020, Canadian online grocer Goodfood Market completed a $30 million principal amount convertible debenture offering to finance the construction of a new online grocery fulfillment anchor in Toronto.
Debentures will have an annual coupon of 5.75%, redeemable at maturity on March 31, 2025 and payable semi-annually. The conversion price of the debentures is $4.70 per share (Source).
The online grocery delivery company is receiving $30 million in financing. In exchange, the company guarantees the repayment of this capital on March 31, 2025 and also commits to pay a semi-annual coupon to investors of 5.75% annually. However, if the company performs well, the convertible debentures can be exercised at a price of $4.70 by investors at any time before the maturity date. By opting for this financing method, Goodfood obtains liquidity more quickly than by issuing new shares, at a lower cost and with non-immediate dilution of the shareholder base.
Pros and Cons of Debentures
Pros of Debentures
For the Lender:
- Due to the possibility of conversion, convertible debentures pay a lower coupon than traditional bonds. Non-convertible debentures pay a coupon that is similar to the traditional bond.
- The transferability of the debenture between investors; this means that one investor can transfer his debenture to another. The debenture is therefore a flexible means of financing and allows investors in a start-up company to adapt to the changing reality of the entrepreneur.
- The principal benefit of a convertible debenture is that it allows the investor to convert his debt into equity, in the event that an increase in the value of the shares is anticipated. This allows an investor in a small business to benefit from the return on equity once the debenture is converted.
- In case of corporate bankruptcy, the debenture is paid before the common shareholders (if the conversion has not been made).
For the Issuer:
- Convertible debentures are a faster and less expensive means of financing than equity financing.
- Although included as a liability on the balance sheet, convertible debentures are considered as quasi-equity for financial ratio calculations. Thus, the debt ratio calculations are better than with regular debt financing.
- The convertibility feature of the debentures attracts a certain investor base and therefore promotes access to financing.
- Does not dilute the shareholding as long as the debentures are not converted into shares.
Cons of Debentures
For the Lender:
- The fixed interest rate of the debenture may involve losses if it does not keep pace with inflation and rising capital market interest rates.
For the Issuer:
- If the lender fails to repay the loan, it may suffer losses greater than the amount of the debenture.
What Are the Risks of Convertible Debentures?
Despite all the benefits of convertible debentures, they are not exempt from certain risks related to the approaching maturity date, the decrease in the company’s equity and the fluctuation of the financial market.
Here are some risks associated with convertible debentures:
Companies involved in convertible debentures find it difficult to refinance their debt portion as they approach the maturity date. This risk arises because there are not enough unencumbered assets to give to a senior secured investor.
Risk of Shareholder Dilution and Actual Loss of Ownership
Under certain conditions where the issuer does not have the means to pay for its convertible debentures or is unable to refinance them, it could repay the lenders by converting the debentures into equity, which could involve significant dilution to current shareholders.
Formal Restructuring Risk
Corporate issuers who are unable to amend, extend or refinance their convertible debentures prior to the maturity date may be required to conclude a formal restructuring arrangement. Maturing debenture issues may also involve covenants with senior lenders.
As previously mentioned, a debenture is a long-term financing tool useful for building up a company’s funds and developing economic activities requiring large budgets.
Cofinia, a specialist in accounting management, financial management and business intelligence will help you throughout your debenture process. Cofinia’s financial experts will suggest the best financial strategy given your SME’s cash flow, balance sheet and desired results.
With optimized financial projections, you can detect any weaknesses and see if your business plan is realistic or not before starting the loan application process.