Definition

• Convertible notes are a mix of debt and equity that start out as normal debt instruments. However, the business that issues the notes offers a feature that allows the investor to turn the note into equity--in other words, the investor can choose to trade the note in and receive shares in the company stock instead. The investor will not receive any payment from the note but has all the benefits of the stock, including ownership in the company.
  
  

Options

• The ability of the investor to convert his note is known as an option. There are many different qualifications that go along with this option. Typically, an investor can only choose to convert the note within a certain time frame, possibly several months after purchase, or a time frame of several weeks, determined by the company. If the investor does choose to convert the note, he receives only a set number of shares and cannot change this number.
  
  

Uses

• Companies use convertible notes when they are willing to create or sell more shares in the company, but do not want to sell more shares immediately. Perhaps immediately selling shares would dilute stock too much for stockholders or dilute ownership in the company at a time when critical decisions need to be made. To raise money in equity during these times, companies create convertible notes to delay investment in shares.
  
  

Benefits

• For the investor, the flexibility of convertible notes is very appealing. If the investor keeps a careful eye on the company and the performance of its stock, he can cash in the note for shares at a time when the share value has increased beyond the value of the note, thus saving money on the share purchase. If the stock value falls, the investor can hold onto the note as a more dependable form of profit.
  
  

Considerations

• Convertible notes are not always a good deal for investors. For instance, a young company still in danger of failing may produce neither reliable debt nor reliable equity, so the extra prices investors usually have to pay for convertible notes would not be worth the increased risk.