A conversion of debenture agreement is a contract between the debenture holder and the issuer company. This contract grants the right to the debenture holder to convert the debentures issued to him to equity in the event of default. Typically, the price at which such conversion will occur is pre-determined.
What is Conversion of Debenture Agreement?
A conversion of debenture agreement is signed between a debenture holder and the company issuing debentures to raise capital. Often, a company is not in a position to pay off the due amount to the debenture holder and in such a condition, they are compelled to pay off the amount by issuing shares equivalent to the amount of the debentures issued so as to cover the liability.
For example, A issues debentures to B in lieu of loans. A fails to repay the debt, B converts these shares and realizes his money. These contracts entail a liability incurred by the issuing company recoverable by the debenture holder. Convertible debentures are hybrid securities which may be used as both equity and bonds, originally issued as bonds these debentures may be, by the issue of notice, be converted to shares on the behest of the debenture holder.
The contract so formed between a debenture holder and the company converting these debentures into equity shares is known as debenture conversion agreement.
Purpose of Conversion of Debenture Agreement
The purpose of such a contract is to provide a simple acknowledgment and outline the requisite clauses that govern such a transfer. It prescribes various rights that are vested on the debenture holder due to this conversion. Since Convertible debentures are hybrid products that strike a balance between debt and equity, debenture holders stand to gain in the sense that they have assured yield of fixed interest payments, while also having the prerogative to convert the loan to equity shares if the company business increases, raising the stocks over price, over time. Having a standard timeline for the conversion of debentures and a pre-agreed price assures the debenture holder.
Inclusions in Conversion of Debenture Agreement
A conversion of debenture agreement typically should include the names of the parties, their relationship and the purpose behind assigning of debentures. As it entitles the holder of debentures for the conversion of the same, it is pertinent to highlight certain default events when such conversion entitlement is triggered. A set of boilerplate clauses like dispute resolution, waiver, notice, severability, etc. should also be a part of this contract.
Key Terms of Conversion of Debenture Agreement
Important terms that must be understood when drafting this agreement are:
- The Conversion Ratio
This clause contains a simple account of the number of shares each debenture can be converted into.
- Repayment Date
The date on which the debentures must be repaid.
As debenture is a kind of loan, the company must pay the interest to its creditors according to the frequency and rate of the interest mentioned in the debenture document.
- The Conversion Price
The standard stock price at which the debenture is convertible into the underlying shares of the issuer.
- The Intrinsic Value (also known as parity or conversion value)
The value of the underlying equity shares to be received if the bond is converted.
- The conversion premium
The premium of the convertible bond’s price over its intrinsic value. It is calculated by simple subtraction of the convertible debenture’s intrinsic value from its price.
Drafting Conversion of Debenture Agreement
A standard debenture conversion contract must lucidly disclose the following points:
- It must mention the number of debentures that are being converted and it should also state the number of shares that will be allotted for the purpose of this conversion. By law, this should not exceed 500 shares per debenture holder.
- It must have the value of each share mentioned and the conversion rate that has been applied.
- It must prescribe the mode of payment of unpaid interest if any and the date of such conversion.
- It must also mention if all the debentures held by the debenture holder are being converted or if only certain debentures are being converted.
- It must also contain the conversion rights accrued by the debenture holder as a new shareholder.
- Assessing the security risks involved, and ensuring they are understood and examined.
- A standard format or template of a debenture conversion contract may be maintained by companies. The details though will vary according to facts and circumstances.
Advantages of a Debenture Conversion Agreement
The advantage of debenture conversion agreements is also that as with any debt instrument, whether it’s a bond or loan, the debt needs to be repaid. Too many debts on the company would only lead to high debt servicing costs that include interest payments. This would eventually result in high debt servicing costs including interest payments and lead to volatile earnings. This issue is mitigated by way of issuing equity shares. This is because equity, unlike debentures, does not require repayment, nor does it require the payment of interest to holders. However, a company might pay dividends to shareholders, which although voluntary, could be seen as a cost of issuing equity since the firm’s retained earnings or accumulated profits would be reduced.
Having a contract governing the conversion of debentures in place is important to provide security to the debenture holder that in the event his loan remains unpaid, he can recover his dues by converting his debentures into equity. It also provides comfort to the issuer company, as it has all the terms and conditions outlined clearly. A violation of the same would enable the suffering party to take recourse to both legal and contractual remedies. The former includes recourse to litigation or arbitration and other such methods of dispute resolution. The latter would entitle the suffering party to sue for damages and breach of contract.
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