Debt in itself can either be in the form of loans or as hybrid instruments in the form of convertible securities such as convertible debentures and bonds. Loans are availed from banks and financial institutions who may not be willing to grant loans to start-ups as there is no asset available for pledge. Therefore, an available option for start-ups is issuing convertible debt to investors.
Investors investing in start-ups who purchase convertible debt are at a more advantageous position that they would have been had they purchased equity. The reason is that, equity represents an inherent risk, i.e. returns are not available till there is significant appreciation of the net worth of the company. This means that till such time that the company does not become a profitable venture the investor cannot sell the shares. This is problematic, as this event may not happen at all. This is where convertible debt is advantageous as the investor has the following options:
(a) Demand his principal amount plus interest: The agreement would guarantee payment of principal amount along with interest at a specified time.
(b) Demand conversion of his loan into securities: If the company becomes profitable within the time period specified for maturity of the instrument demand that his convertible security be converted into equity.
For a company, issuing convertible debt, can be advantageous as there is no automatic conversion of loans into securities, which protects the ownership interests of the promoters.
If you are an entrepreneur looking for investments into your company do consider the option of issuing convertible debt. However, do keep in mind that in case of foreign investors the nature of instrument issued assumes particular importance as optionally convertible debt is classified as external commercial borrowing (ECB) and fully and mandatorily convertible debt is classified as foreign investment (FDI) and respective compliance of FDI / ECB regimes is required.
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