Convertible senior notes, explained
Convertible senior notes are hybrid debt instruments companies use to raise capital without immediate dilution while giving investors the opportunity to convert debt into equity under favorable conditions.
To simplify, a convertible senior note is a type of debt security (loan) that you (as an investor) can convert into shares of the issuing company’s common stock. But you might be wondering what “senior” means here.
The term “senior” means that in the event of the company’s bankruptcy, holders of these notes have priority over other debt holders (like holders of junior notes or unsecured debt) when it comes to repayment.
Here are key terms associated with convertible senior notes that you should be aware of:
- Principal amount: The initial amount borrowed by the company.
- Interest rate: The fixed or variable rate of interest paid on the principal amount.
- Maturity date: The date on which the principal amount is due to be repaid.
- Conversion price: The predetermined price per share at which the note can be converted into shares of the company’s common stock.
- Conversion ratio: The number of shares of common stock into which each note can be converted.
But why would a company issue convertible senior notes? Well, there are many reasons, including:
- Flexible financing: Such instruments allow companies to raise capital, especially in the early stages or during periods of uncertainty.
- Avoid dilution: Unlike traditional equity financing (like selling shares), convertible notes don’t immediately dilute the existing holders’ ownership stake.
- Tax benefits: In some cases, interest payments on convertible notes may be tax-deductible for the company.
Now, a question arises: Why would an investor buy convertible senior notes?
Convertible senior note holders can participate in the company’s growth through equity conversion, making them more attractive than traditional debt. Since they are debt instruments with a fixed interest rate and maturity date, investors get protection against losses.
How convertible notes work for Bitcoin investments
Convertible notes are a hybrid financing tool used in various contexts, including Bitcoin investments.
MicroStrategy is a well-known example of a company that has extensively used convertible notes to fund its Bitcoin (BTC) purchases.
Here’s a simplified explanation of how they work in this context:
- Company issues notes: A company involved in Bitcoin mining or other Bitcoin-related activities might issue convertible notes to raise capital.
- Investor buys notes: Investors purchase these notes, essentially lending money to the company.
- Interest and conversion option: The notes typically have a fixed interest rate and a maturity date. Additionally, they offer the investor the option to convert the note into shares of the company’s stock at a predetermined conversion price.
- Bitcoin exposure: If the company’s business model is heavily tied to Bitcoin, the value of its stock may fluctuate based on the price of Bitcoin.
- Potential upside: If the price of Bitcoin rises and the company performs well, the value of the company’s stock may increase, leading to a significant gain for the investor who converts their notes into shares.
- Downside protection: The note itself is a debt instrument, providing some downside protection. If the company fails, investors may still receive their principal investment back (subject to the company’s financial health).
Did you know? MARA Holdings raised $1 billion by issuing zero-coupon convertible notes, a move that allows them to acquire Bitcoin without paying interest until maturity.
How MicroStrategy uses convertible senior notes to fund Bitcoin acquisitions
MicroStrategy, co-founded by Michael Saylor, has employed a strategic approach involving the issuance of convertible senior notes to finance its significant Bitcoin acquisitions.
Let’s understand how the company acquires BTC via convertible senior notes:
- Issuing convertible notes: The company has issued multiple rounds of convertible senior notes to raise capital; these notes typically have a fixed maturity date and a zero-coupon structure, meaning they don’t pay periodic interest. MicroStrategy began its Bitcoin journey in 2020 with a $250-million cash purchase. Since then, it has raised over $3 billion through convertible notes to fund further Bitcoin acquisitions.
- Using proceeds to buy BTC: The funds raised from these notes have been primarily allocated to purchase Bitcoin, significantly increasing MicroStrategy’s Bitcoin holdings. As of Dec. 3, 2024, the company holds approximately 402,100 BTC (1.915% of the total supply of 21 million BTC).
- Leveraging Bitcoin’s potential: By investing heavily in Bitcoin, MicroStrategy aims to capitalize on the long-term appreciation of the cryptocurrency. For instance, if the price of BTC rises, the value of MicroStrategy’s Bitcoin holdings increases, potentially boosting the company’s stock (MSTR) price.
On Nov. 20, 2024, MicroStrategy announced the pricing of a $2.6-billion offering of 0% convertible senior notes due 2029. Key details of this offering include:
- Zero-coupon structure: The notes do not pay periodic interest.
- Conversion option: Holders can convert the notes into shares of MicroStrategy’s common stock at a conversion price of $672.40 per share.
- Maturity date: The notes mature in December 2029.
- Redemption option: MicroStrategy has the option to redeem the notes starting in December 2026 under specific conditions, particularly if its stock price reaches 130% of the conversion price for a certain period. If redeemed, investors receive 100% of the principal plus accrued interest. Notably, other factors might influence the redemption decision.
This approach has worked to MicroStrategy’s advantage, with the company delivering an annualized return of 80% between 2020 and 2024, outperforming Bitcoin itself. Since mid-2020, MicroStrategy has outperformed all major US stocks, including Nvidia, due to its strategy of accumulating Bitcoin.
The company’s stock has surged by over 2,500% since August 2020, while Bitcoin has experienced a 660% rise during the same timeframe. This performance underscores the significant impact of Bitcoin’s appreciation on MicroStrategy’s market success.
However, investors should note the higher volatility and risk associated with the company’s strategy, which is heavily tied to Bitcoin’s long-term growth potential.
Did you know? Uber raised $1.5 billion through the pricing of its upsized convertible senior notes offering, which is due in 2028. This offering is part of Uber’s broader strategy to manage its debt and capital structure.
Benefits of convertible senior notes
Convertible senior notes appeal to companies looking to raise capital efficiently while maintaining flexibility and minimizing immediate dilution.
For companies like MicroStrategy, convertible senior notes offer the following advantages:
- Reduced interest costs: The zero-coupon structure of the notes eliminates the need for periodic interest payments, reducing the company’s financing costs.
- Lower issuance costs: Compared to traditional debt or equity issuance, convertible senior notes typically involve lower upfront costs for the company, especially when compared to issuing straight debt or undertaking an equity offering, which often involve more extensive underwriting (the process of assessing, pricing and assuming risk for issuing new securities) and fees.
- Capital acquisition: Such instruments provide a flexible way for MicroStrategy to raise capital without diluting existing shareholders immediately.
- Investor appeal: Convertible notes can attract investors who are seeking exposure to both the company’s traditional business and its Bitcoin holdings.
Risks associated with convertible senior notes
While MicroStrategy manages financial risks through a hybrid debt-equity instrument, its investment approach is not risk-free.
Here are some potential risks to consider:
- Bitcoin price volatility: The value of MicroStrategy’s Bitcoin holdings is subject to significant price fluctuations, which can impact the company’s financial performance.
- Regulatory uncertainty: The constantly evolving regulatory environment for cryptocurrencies could introduce additional risks for the company.
- Conversion risk: If MSTR’s price falls below the conversion price, investors may not choose to convert their notes into shares, leading to potential dilution for existing shareholders.
- Market timing and hedging risks: MicroStrategy bets on the long-term appreciation of Bitcoin — i.e., assuming an optimistic market outlook. If Bitcoin were to face a prolonged bear market, this strategy could backfire, as the company would be left with large debt obligations and potentially lower Bitcoin asset values.
- Rising interest rates: The cost of borrowing — particularly in a rising interest rate environment — could increase the pressure on companies issuing hybrid instruments. Rising interest rates increase the cost of servicing debt, posing additional financial burdens for companies employing this strategy.
Overall, the sustainability of MicroStrategy’s bold strategy of using convertible senior notes to fund significant Bitcoin purchases hinges on both financial principles and the broader economic landscape.
The risk is particularly pronounced for investors who may not fully understand or agree with the rationale behind holding such a volatile asset on the balance sheet. Thus, to ensure long-term sustainability, companies must adopt a balanced approach, integrating market analysis, risk management strategies and flexible capital planning.
