Hybrids
Hybrid forms of financing have characteristics that cause them to lean away from equity or away from
debt. In other words, they have some features that are commonly associated with borrowing AND
features that are associated with equity. They came about for a very simple reason. Companies and
investors decided that straight borrowing wouldn’t work well, and straight equity wouldn’t work well,
and both the companies and investors would prefer this “in between” financing vehicle. We are going
to discuss a couple examples with some depth here. Let’s start with the basics. Companies can either
issue shares of equity or borrow to get external funding. Here is a mapping of some of the more salient
characteristics for comparison:
Feature Equity Debt
Must Pay Back X
Required Interest Payments X
Potentially reduces flexibility X
Loss of ownership X
Possible loss of control X
Share upside rewards X
Downside risk X X
Convertible Debt
One hybrid source of financing is Convertible Debt. This is essentially a plain vanilla borrowing
arrangement (the company makes interest payments periodically then repays the entire principal
balance at maturity). Except the lender has the right to convert the debt into shares of equity.
Say you are the only owner in a business where there are 80 shares of equity. You need funding to
grow, and you don’t want to share ownership at this point in the company’s life, so you decide to
borrow and a lender makes you an offer of $55,000 at an annual interest rate of 10% for five years. Or,
the lender says you can borrow the $55,000 at an annual interest rate of 7%, but at the third year, the
lender can convert the $55,000 loan into 20 shares of stock. You estimate that the business is currently
worth a total of $150,000. In essence, at this point in time, you own 100% of a business worth
$150,000.
What are the possible benefits and drawbacks of the convertible debt for you and the lender, compared
to a traditional plain vanilla loan?
For you, the convertible debt carries a must lower interest rate, so the interest cost per year would only
be $38,500 instead of $55,000. Second, you do not need to take an additional owner for at least
another three years and perhaps longer if the lender doesn’t convert the loan into shares of stock. The
drawback for you is that you may need to take on an additional owner.
For the lender, you receive a lower interest payment from the business, but you have the right to own
part of the business three years from now.
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Perhaps we can look at a couple of paths that the business can take over the next few years and see
how each person does under these scenarios. One scenario is that the business is not doing as well as
you would have hoped and is in the same financial position or worse. In this instance, the business will
be better off with the lowest interest rate of the convertible debt, and the lender still receives a
respectable rate of return, and perhaps the higher rate on a traditional loan would have put the
business in an even more precarious position. Also, it is unlikely that the lender would convert the loan
over to shares of stock, as the interest payments plus the repayment of principal is likely worth more
than the share of the business the lender would receive. A second scenario is more optimistic. The
lower interest rate allows the owner more flexibility to grow the business (compared to the interest rate
on the traditional loan) and in three years the business is worth $500,000. At that time, the lender
decides to convert the loan over to 20 shares of stock. So you own 80 shares and the former lender
owns 20 shares. In a $500,000 business, your share would now be worth $400,000 and the former
lender’s share is worth $100,000. Compared to the loan of $55,000 and the two remaining interest
payments, this is much better for the lender, and your 80% share of the business is worth much more
than 100% of the business previously. And you no longer need to make further payments to the loan –
they are effectively erased.
If you knew which path the business would take, this wouldn’t be an issue. You would take the
convertible debt in the pessimistic scenario to reduce your costs and you would take the traditional debt
in the optimistic scenario. But the lender would want the reverse, the traditional debt in the pessimistic
scenario and the convertible debt in the optimistic scenario. So your interests are not necessarily
aligned. But with convertible debt, they become more closely in sync. If the business isn’t doing well,
then both parties want the business to survive. If the business is doing very well, both parties want to
share in the upside. Convertible debt becomes a vehicle that at least more closely aligns the risk and
return for both the business owner and the investor.
Preferred Equity
Another form of hybrid financing is preferred equity. Preferred equity is NOT typically ownership in the
business. Ownership is reserved for equity (also called common equity). Preferred equity does come
with the promise of specific dividends, normally paid once every three months. It is called “preferred”
because in the event that the business has difficulties, preferred equity-holders will receive benefits
prior to common equity-holders. An example of preferred equity would be something like, you receive
$2,000 and provide 10 shares of preferred equity to an investor, who you have to pay $20 every three
months total. So the investor will receive a total of $80 in dividends per year, which would be a 4%
return [calculation: $80 dividends / $2000 investment]. The preferred equity does not have a maturity
or need to be repaid. Also, most forms of preferred equity are “cumulative”; that is, the business can
choose to skip the $80 dividend, but must then add the missed dividend to a future payment. Finally,
some preferred equity shares can be converted into common equity…so we could technically have
“cumulative convertible preferred equity”.
The idea here isn’t to make life complicated for everyone, but rather to help the business when it needs
help, and for everyone to be able to share in the upside. So for preferred equity, if the business isn’t
doing well, the company can choose to miss a dividend payment to give it some temporary relief from a
[Link] © 2017 Mark Potter. All rights reserved.
financial cost. And if the business is doing really well, and there is a conversion feature, the preferred
equity can be converted into common equity and share in the success of the business.
[Link] © 2017 Mark Potter. All rights reserved.