Convertible Notes: The Good, the Bad, and the Ugly

Convertible notes have become an increasingly popular source of finance for ASX companies over the past few years.

Versions of these products have appealed in particular to small and micro cap resources companies in need of fast cash to keep fledgling development projects alive.

The notes do, however, have their critics, particularly where companies which have issued them experience sharp share price declines.

Is this criticism fair or are the benefits of the notes being too readily ignored in favour of the negative views?

And do companies have alternatives to entering into the positions in the first place?

Below we attempt to explain how standard Australian convertible note positions work and explore alternatives available to capital hungry companies.

Convertible Notes Explained

Convertible notes are debt like agreements under which a company receives money from an investor upfront in return for making future principal and/or interest payments.

Unlike standard debt finance, convertible notes contain an option for settlement in shares in lieu of cash.

Typical Deal Terms

Convertible note terms are very much bespoke and often hugely complex.

Deals done in Australia have, however, tended towards a standardised form and typically include the following features:

Note facility: a company issues a series of notes to an investor under a facility agreement. The facility size is usually around five times the size of the first note issued and is rarely used to its full capacity.

Face value: each note has a specified face value, which is the principal amount that needs to be repaid by the company to the investor. A ‘face value discount’ results in the upfront cash payment received by the company for the note being less than the face value, allowing the investor to earn a profit.

Repayment option: while companies have the right to settle convertible notes in cash, in virtually all cases they opt to instead settle by issuing shares to the investor. The number of shares the company is required to issue is determined by the share conversion price.

Share conversion price: the share conversion price is determined by applying a discount to the company share price. The discount is typically 10 per cent to 20 per cent of the average of the lowest five daily share prices over the 20 trading days preceding note repayment. This approach yields a share conversion price which is typically 15 per cent to 30 per cent below the average share price over the period.

Early termination: early termination allows the investor or the company to exit the facility before its maturity under certain conditions. The company is ordinarily able to exit only after paying an exit fee to the investor in addition to repaying all outstanding note amounts.

Option issuance: investors often receive three year options to buy shares in the company as part of the note facility agreement. These options are issued at strikes of around 125 per cent of the original company share price.

The Good

The most clear and important benefit offered by convertible notes is the immediate injection of cash into company accounts.

This benefit cannot be underestimated, particularly for companies which have critically low cash balances and are in the pre production phase or for companies looking to quickly embark on exploration and development projects.

Convertible notes also have the benefit of tailorable terms.

This gives companies the flexibility to negotiate terms which better suit them, by for example issuing more options in exchange for a smaller share conversion price discount.

This is sometimes easier said than done given that negotiating power often rests with the investor.

Finally, convertible notes allow a listed company to take advantage of one of its great untapped assets: its listed status.

The costs of compliance and reporting for a listed company are very high. For early stage companies, these costs are arguably justifiable only where the company is consistently issuing shares into the market to raise capital.

A convertible note is a fantastic tool for doing exactly this.

Furthermore, the note does it in a way which minimises management effort by avoiding prospectus documents and road shows, allowing management to better focus on company operations.

The Bad

Convertible notes represent an expensive form of capital.

Costs are incurred by the company through upfront fees, exit fees, option issuance, the face value discount and the share conversion price discount.

To put these costs in perspective, if we assume a company establishes a $5 million facility which it uses to one third capacity before terminating (a typical scenario in the Australian market), the company will issue notes to the investor of total face value $1.67 million.

Applying a standard face value discount of 10 per cent to this amount, the company will receive a cash payment of $1.5 million for the notes.

The table below illustrates the overall cost picture assuming share settlement with an average share conversion price discount of 20 per cent.

 

In addition to high cost, convertible notes can offer limited flexibility should company circumstances change.

Note terms typically require that a minimum portion of the facility size be issued prior to the company having the right to close the facility out.

This means that the company may be forced to raise more capital than it truly requires and limits the ability to opt for an alternative form of capital should one become available.

In the atypical scenario where the company pays cash to settle the note rather than issues shares, the cash payment is typically due between three and six months from the issuance date.

The 10 per cent note issuance discount therefore translates into an effective annual rate of interest of between 21 per cent and 46 per cent before upfront fees and option cost are taken into account.

The Ugly

The biggest concern faced by companies issuing convertible notes is the potential for a large and sustained drop in share price.

Shares are often issued in large parcels to cover the obligations under the note.

These are typically sold into the market, putting downward pressure on the share price.

Under the terms of the note, obligations are fixed in dollar terms rather than in share terms.

As the share price drops, a greater number of shares are needed to cover a given dollar repayment.

These additional shares cause increased shareholder dilution and further and accelerated downward price pressure.

This process has the potential to turn into a vicious ‘death spiral’ and drive the share price well below its initial level.

Alternatives

In addition to traditional placements, right issues and prospectus based raises, alternatives to convertible notes for listed companies do exist but have yet to be taken up in the Australian market.

Acuity Capital’s Controlled Placement Agreement (CPA) provides listed companies with control over the capital raising process.

The CPA allows companies to decide the frequency, timing, maximum size and minimum issue price of anycapital raised.

In this way, companies can be flexible in their approach to raising capital and quickly take advantage of short term changes in market or stock specific conditions.

A convertible note is potentially well suited to companies requiring immediate injections of cash.

Although the CPA can raise large amounts of capital in short periods of time, it is more suited to a proactive forward looking capital management plan and critically does not require a company to issue any shares should a change in circumstances remove the need for such action.

The Bottom Line

Convertible notes are complex products which take real work to properly understand.

While they do have their pitfalls, they also have the potential to rescue fledgling companies from impending insolvency, providing executives with the time and money they need to create long term shareholder value.

The key for company executives is to have their eyes open when using convertible notes and to understand the alternatives available to them to ensure the right capital solutions are employed.

Stephen Earl and Mark Hergott are directors at Acuity Capital, an Australian based, owned and operated provider of capital raising solutions for ASX-listed companies.

For more information:

Email
info@acuitycapital.com.au

Website
www.acuitycapital.com.au.