when a start-up converts debt to equity, how should an analyst read into this? the start-up reduced its debt or the start-up does not have enough cash to pay off its debt?
generally positive. the bondholders believe that the company is worth much more than book value. all start-ups have cash flow problems…
Wait a sec…What kind of start-up is able to issue debt to begin with? Generally speaking start-ups get equity financing or bank loans. They don’t normally have the established cash flows or assets to get anyone to underwrite debt for them. If somehow they were able to issue debt and those bondholders were convinced to convert into equity then I’d say there’s trouble. If everything was fine there would be no way the owners would want to dilute their shares. Without any further info, I’d say the company is having (new) cash flow problems.
yep, start-up with debt sounds suspect
Mobius Striptease Wrote: ------------------------------------------------------- > yep, start-up with debt sounds suspect +1. start ups usually get angel funding, which the angels never really expect to recover. we’ve all read the VC info in the cfai text, right? its usually always equity, debt once established. plus, start-ups usually have very little collateral to post for any kind of debt where the lender would have recourse
say for example, a loan arrangement where there is an option attached and the loan may convert to equity or debt? i used the word start-up very loosely, i actually meant a new small public company with some assets on its books.
say for example, a loan arrangement where there is an option attached and the loan may convert to equity or debt? i used the word start-up very loosely, i actually meant a new small public company with some assets on its books.
one stock i am watching sells at 6cents. the company is small and has not turned over much in the previous year. it has only started to sell product very recently. and the stock rallied to 6cents. now there is a loan arrangement where the lender has the option to covert the loan to equity to 4 cents due as well. is it normal for the stock to go up to 6c when you know that someone else are going to sell/buy it at 4c?
one stock i am watching sells at 6cents. the company is small and has not turned over much in the previous year. it has only started to sell product very recently. and the stock rallied to 6cents. now there is a loan arrangement where the lender has the option to covert the loan to equity to 4 cents due as well. is it normal for the stock to go up to 6c when you know that someone else are going to sell/buy it at 4c?
A lot of start-ups get convertible preferred equity, which is basically like debt in that it often has a small dividend (essentially the same as a low interest rate) and gets converted to equity at the IPO stage. This is known and expected and is a non-factor in the equity analysis – this is a typical VC exit strategy. One thing to be aware of though is that the VC may not sell all of its shares to the public in the IPO, which, if the position is large enough, could create the perception of an overhang in the stock further down the road.
so essentially you are talking about a convertible debt financing, which is common for small risky public companies. they add the conversion option in the debt as a sweetener to lower their otherwise ridiculously high coupon rate and preserve cash. there is nothing wrong with the stock price rising above the conversion price so that the conversion option becomes in the money. the dilutive effect upon conversion should already be factored into the stock price assuming the convertible’s issuance is a public information and markets are efficient. i’d be skeptical about the “market efficiency” component of the argument for a stock trading at 6 cents, those OTC penny stocks are probably not very liquid. also just because the lender has the option to convert, and the conversion option is in the money, that doesn’t mean the will or should convert - in fact, they are better off holding the bond, collecting the small coupon, and waiting for the stock to appreciate more.
What people have said. Debt instruments can be convertible. If that is the case, it’s rather a good sign. However, how are the numbers looking ? When the company is undergoing difficulties, bond holders sometimes agree to convert their debt into equity and not liquidate the company. If that is the case, it can’t be good.
Yeah, we were talking about two different things. When equity owners go to debtholders and beg them to convert to equity because they don’t have the cash flows to make the interest payments, that’s a bad thing. When someone owns covertible debt and they want to make the conversion to equity that’s generally a good sign because the stock must be doing well. Plus, any additional shares created by the conversion should have already been factored into the diluted shares outstanding.
Viceroy Wrote: ------------------------------------------------------- > What people have said. Debt instruments can be > convertible. If that is the case, it’s rather a > good sign. > > However, how are the numbers looking ? When the > company is undergoing difficulties, bond holders > sometimes agree to convert their debt into equity > and not liquidate the company. If that is the > case, it can’t be good. in either case its good. if convertible debt and its exercised, its good b/c growth assumptions have likely gone up. if the debt is non-convertible and bondholders had not elected to convert, the company would be dead. instead, its alive. the market must have known that the company was in rough times if bondholders had to convert. so long as the company’s life is longer than was anticipated prior to conversion, option value goes up, and value to common shareholders goes up (assuming the conversion doesn’t dilute current shareholders down to 0.000000000001% of the company or something like that). conversion outside of bankruptcy is almost always positive to common shareholders. it shows bondholder confidence in the company.
^Tell that to YRC shareholders (I bought some after the conversion but still). In most cases I think you’ll find when debt is forced into equity the dilution is always extreme because the equity was almost wiped out anyway. And, it’s normally a last ditch effort. It may stave off bankrupcy for a little while, but I wouldn’t call it a good sign.
^^ exactly. No good. Better than liquidation, but still no good.
yeah but if the market/analysts are pricing the security with these probabilities, which are common: numbers below are arbitrary of course… 30% bankruptcy (EV = $0) 50% restructuring (EV = $100) 20% new cash (though the debt issue is not solved, just delayed) (EV = $110) current value = $72 removing the bankruptcy option and seeing the restructuring happen value would equal $100. almost always, restructuring adds more to shareholder value as it removes the probability of bankruptcy from the stock’s EV. YRCW is a bad example b/c full default was already assumed if you looked at credit markets. I would consider YRC to have been IN bankruptcy as of October 2008 (meaning common shareholders were already powerless and bondholders had already grabbed the reigns). also, we’re talking about valuation, not market pricing. GM stock still has $250M in value yet has no assets, so going by how the market reacts isn’t exactly scientific. the vast majority of analysts had already given YRCW stock a value of $0 before the restructuring, so from a fundamental POV, the restructuring did add value to YRCW shares.
MattLikesAnalysis Wrote: ------------------------------------------------------- > from a fundamental POV, the restructuring did add > value to YRCW shares. Obviously I don’t disagree since I bought shares after they restructured. Still, I went into it as a pure gamble. I’m fully prepared for YRCW to go to zero. And, I agree if the alternative is bankruptcy then sure it’s a good thing. But, the fact a company is unable to meet debt obligations is never a good thing. Simply by removing the interest payments isn’t going to suddenly make the problems go away, it just buys time.
you both agree that converting debt to equity can be a relative good, but not an absolute good. i’m good with that
good