Convertible Debt Interest Rate

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Permalink Reply by Werner Reisacher on April 19, 2010 at 12:45pm

There are many ways to solve this problem mathematically. But in the real world, the decision will be driven by the market. The interest rate will be the rate an the investor demands based on his perception of the existing risk related to his investment decision.
Werner Reisacher

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Permalink Reply by Sachidanand (Sacha) Singh on April 28, 2010 at 4:17am

A simple formulation would go: A convertible gives the lender an option to buy the shares. Suppose face value of the convertible is 1000, the fair value of the option embedded in it is "option value", cost of straight debt is d%; coupon of convertible should be (1000-option value)*d%.

But as Werner says, it all depends on investors' risk perceptions.

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Permalink Reply by Kostadin Panayotov on May 4, 2010 at 8:12am

The formula Sachidanand pointed out is absolutely correct, but i think the convertibles will be treated rather a debt security than an equity security. As far as it is a start-up company concerned, the option value as of today will rather be close to zero. And having the uncertainties on future earnings, the spread may be some basis points higher than 3-6%. And again, it is the investor with the final word.

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Permalink Reply by Nathan Beckord on May 4, 2010 at 12:28pm

Yes, as the others point out, there is the "financial theory" way to approach it and the "real world" approach. Practically speaking, the interest rate on a convertible note for a startup is often 8 to 10%. I have reviewed and/or negotiated several of these, and that range is quite typical (indeed, it is often the case that the investor starts at 10% and if the entrepreneur has leverage/interest in the deal, we negotiate down to 8%, etc.). Other terms are equally important and also negotiated, such as whether the interest is cumulative or non-cumulative.

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