Debenture

Debentures are one form of corporate note, under which a company borrows money and agrees to repay it, with interest. They represent a legitimate alternative for companies to raise funds without selling equity. Many investors fund both debt and equity and use debentures to reflect the debt portion.

Investors sometimes use debentures to increase their return on investment. This happens when they characterize a portion of their equity investment as a debenture while computing the amount of stock they require on their total equity and debenture investment. When this is done, the investor receives money as a debt repayment without reducing his potential return from the stock purchase. If the investment is only moderately successful, the debenture also helps the investor reclaim a portion of his money for investment in another company.

How can characterizing a portion of an investment as a debenture benefit investors at the expense of management? Assume, for example, that an investor agrees to provide $600,000 in return for 30 percent of a company’s outstanding stock. The investor wants to pay $100,000 for the stock and $500,000 for a debenture. The debenture proposed will have a term of ten years, and the company will not have to repay any principal or interest until then. In the meantime, if the company generates enough profits to pay off some of the debenture without hurting cash flow, then the company will begin to do so.

The investor’s preference for this structure is clear. If he invests all $600,000 in the stock and the company succeeds, his initial investment may pay back $2 million, for example, making his profit $1.4 million. If, instead, he puts $100,000 in the stock and $500,000 in a debenture, his profit will be more than $1.9 million because in addition to the $2 million he also gets paid back his $500,000, with interest. In the first case his return on his stock investment is 2.3 to 1; in the second case it is more than 19 to 1!

But does it matter to the company? Should the company begrudge the investor a higher return as long as it does not cost more? Consider the following:

The investor argues that the structure does not hurt the company or management. The company still gets $600,000. If it does well and meets its projections, the company can pay back the debenture early. If the company does not do well enough by the tenth year to pay back the debenture, it probably will not matter because, he says, management will probably have abandoned the project by then anyway. It is a corporate debt, after all, and if the company cannot make the payment, it will not be doing well enough to keep the entrepreneur’s loyalty anyway. There’s no personal liability (at least, not now), so management should not care.

The proposed structure does allow the company to use the $500,000 without making interest payments during the start-up years of its operations. It may even help the company to borrow other funds as long as the debenture holder’s rights are subordinated to another lender’s. It will not, however, improve the company’s balance sheet to the same extent or give a lender as much comfort as an equity investment will.

The terms of a typical debenture require a company to start repayment after three or four years of operations (if the company is generating enough cash). If the company is expanding at that point, as everyone hopes it will be, management may need cash to support larger inventories or more ambitious marketing efforts. Therefore, if management agrees to the investor’s proposed structure, the company may incur the expense of further borrowing earlier than it would have had to if the original investment had been all for stock.

Thus, the use of a debenture reduces the value to the company of the venture capitalist’s investment. It may not reduce it below what is needed to get the company started, but it does reduce it in a measurable way. As a result, companies should try to structure debentures they issue in ways that reduce and delay their adverse effects. Here are some ways to accomplish this:

• Make the term as long as possible. The longer the company has the money to use before it has to repay the loan, the more like equity it is to the company. (This also applies to interest payments and early principal payments required by the terms of the debenture. These principal “prepayments” typically become due when the company exceeds its projected profits.) To the extent possible, these obligations should be delayed even if they are made contingent upon the success of the company’s operations.

• Reduce the portion of the investment made as a debenture and make required prepayments small. Ideally, any prepayment obligation should be small, start late, and be at management’s option. If the investor wants interest on optional prepayments that the company chooses not to make, payment of that interest should not be required until late in the term of the debenture. The financing agreements should make it clear that any failure to make prepayments or interest payments before the end of the term will not give the investor any rights to require earlier payments under the debenture.

• Persuade investors to subordinate their debentures to other debt of the company. This will make it easier for the company to borrow additional cash, which, in turn, makes it easier for the company to succeed. Success of the company, after all, is the primary goal of management and the venture capitalist; without that success the debenture is worthless.

• Negotiate a right for the company to force the investor to convert the debenture if certain events occur. For example, if the company meets its performance goals, give management the option to force conversion of the debenture into equity and thereby improve the company’s debt-to-equity ratio and make it easier for the company to borrow from outside lenders. Management may choose not to exercise the option if new equity is cheaper than new debt, but the option could prove valuable in the right situation.

You can also try to convince investors to make the company’s payments on the debentures contingent on company success and not require an absolute obligation for the company to repay the debenture at the end of ten years. But do not expect an investor to be too sympathetic to this suggestion. Without a definite repayment obligation, the IRS may treat principal repayments under a debenture as dividends to the investor. This means unwanted taxable income to the investor and reduces the debenture’s after-tax value. As long as the IRS recognizes the debenture as a legitimate debt, repayments of principal create no income and no taxes to the investor.

The use of a long-term debenture does not decrease the risk to the venture capitalist that he will lose all of his money if the company fails. It does, however, increase the size of his reward if the company succeeds. At the same time, the debenture decreases the value of what the company receives from the venture capitalist. This being the case, there is a basis for management to argue that the venture capitalist should be entitled to less stock for his investment when a debenture is included in the funding structure.

Do not confuse debentures with convertible debentures. ‘Straight’ debentures do not give investors any option to buy additional stock. Convertible debentures do. If a venture capitalist requests convertible debentures, be sure the number of shares the company is willing to sell equals the number he buys outright plus the number his convertible debenture entitles him to buy.