Convertible Notes: How Debt Turns Into New Shares

Some notes turn into more shares every time the stock falls. Halve the price and you double the shares. That one feature separates the convertibles a holder can live with from the ones that can take a small company’s share count apart, and both kinds are called convertible notes in the filing.

Start with the ordinary kind. A company borrows and pays interest. The lender may take stock in place of repayment at a fixed price, normally set above where the stock traded when the notes were sold. If the stock stays below it, the lender takes the principal back at maturity. If the stock climbs well past it, converting pays. New shares appear.

Fixed conversion price

A hypothetical company sells $50,000,000 of notes. The conversion price is $25 and the stock trades at $20.

Filings often state the conversion rate and leave the price to you. Divide $1,000 by the rate to get the price back. When the stock hovers just below the conversion price, the notes sit on the balance sheet as plain debt while carrying a share count that a few strong weeks of trading can make real, which is why the conversion price is a level worth marking on your chart. For the fixed kind, 2,000,000 is the ceiling. Splits and special dividends can adjust it, as the indenture spells out.

Variable conversion price

Some small companies borrow on different terms. Their notes convert at a percentage of the market price. The market price is usually measured over a short window of recent trading days.

The price halved and the share count doubled. That is the mechanism to understand here, because it feeds on itself: the holder converts, sells the new shares, the extra supply pushes the price lower, the next conversion happens at a lower price, and each round issues more stock than the one before, until either the note is used up or the company runs short of authorized shares. Some notes set a floor price. Many do not. A company that is running out of authorized shares may then ask holders to vote for more, and that proxy is often the first place a reader sees how far the conversions have gone.

Where to read the terms

The debt note in the 10-K or 10-Q is the first stop. It gives the principal outstanding, the interest rate, the maturity, the conversion price or rate, and usually a summary of any variable pricing, and it deserves a look before the stock compensation note, since a single convert can carry more potential shares than every employee option the company has granted put together.

The full terms live in the indenture or note agreement. It is filed as an exhibit. Floors, caps, cash-settlement rights and the exact pricing window are all in there, in legal language, and small-company notes sometimes hide the most important clause several pages in.

Conversion shares belong in a fully diluted share count. Diluted EPS handles them with the if-converted method, which counts the shares and adds the interest, net of tax, back to net income.

What people get wrong

A convertible gets filed mentally as debt and forgotten. On the balance sheet it is debt. For a holder it is also potential stock. A rally through the conversion price starts issuing it.

Variable-price notes get modeled with today’s price. That gives the count at today’s price only, and a falling stock raises it. Run the sum at half the price too. Put both into the share dilution calculator to see your stake at each. Warrants often ride along with these financings, as covered in stock warrants are dilution on a delay. Practice tracing new shares with the where did the new shares come from quiz.