What it means
A fully convertible debenture, often shortened to FCD, sits between lending and owning. The holder starts out as a creditor earning a fixed coupon, and on the conversion date the whole of the principal is exchanged for ordinary shares at a price written into the original contract.
Companies like the structure because it raises cash cheaply and never has to be repaid in cash. Investors accept a lower coupon than a plain bond would command, since they are also being handed a claim on future equity value, and the borrowing leaves the balance sheet at conversion instead of draining the bank account.
The mechanics rest on the conversion price, which is the per-share price at which the principal is swapped for stock. Dividing the face value by that conversion price gives the conversion ratio, the number of shares the holder ends up with, and multiplying that ratio by the market price gives the conversion value on the day.
It helps to know the neighbouring instruments. A partly convertible debenture converts only a slice of the face value and repays the rest in cash, while an optionally convertible debenture leaves the decision to the holder; "fully convertible" means the whole amount converts and nobody gets a choice.
Existing shareholders should watch the dilution that conversion creates. New shares are issued at the conversion price rather than the market price, so earnings per share falls unless the money raised has been put to profitable work, which is why accountants include these prospective shares in the diluted earnings per share calculation well before conversion day.
In practice
Real-world examples.
Example
A regional logistics operator raises $5,000,000 through fully convertible debentures carrying a 5% coupon and a conversion price of $40 per share, funding a new depot. Three years later the depot is profitable and the shares trade at $58, so the holders convert into 125,000 shares rather than being repaid in cash.
Example
A family-owned engineering group brings in an outside investor who insists on a fully convertible debenture instead of buying shares straight away. The investor earns interest while the founders finish a restructuring, and only converts into a minority stake once the accounts have been signed off cleanly.
Example
A listed software firm's finance chief has to explain to the board why diluted earnings per share is lower than basic earnings per share. The answer is a $12,000,000 fully convertible debenture issued last year, whose future shares are already counted in the diluted figure even though conversion is two years away.
Formula
Calculation
Conversion ratio = Face value / Conversion price
Conversion value = Conversion ratio x Market price per share
Harbour Line Foods issues a fully convertible debenture with a face value of $1,000, a coupon of 6% paid annually, and a conversion price of $25 per share, converting after three years.
Conversion ratio = $1,000 / $25 = 40 shares.
Interest collected over three years = $1,000 x 6% x 3 = $180.
If the shares trade at $32 on the conversion date, conversion value = 40 x $32 = $1,280, so the holder ends with $1,280 of stock plus $180 of interest, or $1,460 in total on $1,000 lent.
If instead the shares trade at $20, conversion value = 40 x $20 = $800, and because conversion is compulsory the holder ends with $800 of stock plus $180 of interest, or $980, a loss against the amount originally lent.Case study
Seen in the real world.
Meridian Tidal Power, an illustrative and entirely fictional marine energy developer, needed $8,000,000 to finish a test site but had almost no profit and could not support a normal bank loan. It issued fully convertible debentures with a 4% annual coupon and a conversion price of $16 per share, converting after four years.
The low coupon kept cash interest to $320,000 a year, which the company could just about afford, and investors accepted that thin income because conversion would hand them 500,000 shares. By year four the test site was selling power and the shares traded at $23, so conversion produced $11,500,000 of stock value against the $8,000,000 originally lent.
The finance director's honest reflection afterwards was that the founders had given away more than they intended. Had the company been able to wait a year and sell ordinary shares at $23, it would have issued roughly 348,000 shares for the same $8,000,000 rather than 500,000, and the founders would have kept a noticeably larger slice of the business.
Watch out
Common mistakes.
- Treating a fully convertible debenture as safe debt that will be repaid in cash. The principal is never returned in money; it comes back as shares whose value may sit well below the face value of the note.
- Ignoring dilution until the conversion date arrives. The shares are already reflected in diluted earnings per share and in any sensible ownership table from the day the debenture is issued.
- Confusing the conversion price with the market price on the day of issue. The conversion price is a fixed contractual number and is often deliberately set at a premium to the market price at the time of signing.
Questions
People also ask.
What happens if the share price sits below the conversion price at maturity?
Conversion still goes ahead, and the holder receives stock worth less than the amount lent, which is the central risk of the instrument.
Does the interest stop once conversion happens?
Yes, the borrowing ceases to exist at conversion, so the coupon stops and the holder receives dividends from then on, if any are declared.
Is a fully convertible debenture shown as debt or equity?
Accounting rules usually split it, showing a liability for the borrowing and a separate equity component for the conversion right until conversion actually takes place.
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