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Classification of Debt securities in corporate financing
A company can issue a variety of debt securities. The permutations of the forms debt can take are ultimately limited only by the requirements of the company and the investors and the creativity of the company’s attorneys.
Debt is classified by its maturity as either long term or short term. Long-term debt is usually due more than 12 months from the date of issue; short-term debt is due in less than 12 months from the date of issue. The portion of long-term debt due within a year appears on the balance sheet as current maturities of long-term debt.
In corporate financing, debt securities are classified as
- Long-term Debt
- Senior Debt
- Convertible Debt.
1. Long-Term debt
Long-term debt with a maturity of less than seven years is usually termed a note. There are two classifications of longer-term debt:
- debentures, which are unsecured by property and
- bonds, which are secured by property (usually real estate).
Debt may be senior or subordinated regardless of its maturity.
2. Senior Debt
Senior debt is the lowest-risk form a lender can use because it has priority on a company’s available assets in case of liquidation. Because subordinated debt receives payment in liquidation only after the senior debt’s claims are satisfied, it is higher risk than senior debt. Subordinated debt therefore normally must offer the lender higher interest rates than senior debt.
3. Convertible debt
Convertible debt can be converted into the common stock of a company under certain predefined terms and conditions. The issuing company usually has the right to call the debt. This provision allows the company to force conversion when the current stock price is higher than the call price.
The call price is normally set above the conversion price. This allows the debt owners to enjoy some appreciation of the common stock before they are forced to convert and, for institutional holders, to sell the equity Without a call feature, the debt owners would have no reason to convert until the cash dividend on the common stock was appreciably greater than the interest on the debt.
KEY POINT: Debt is rarely used to finance startup or early-stage companies, particularly if the financing is provided by friends and family or angel investors. Professional investors, such as venture capitalists, often prefer securities that combine features of debt and equity. This compound structure helps to increase the certainty of the investment’s repayment (a benefit of debt) while also maximizing the investors’ control of the business and their participation in the upside of the business (a benefit of equity).
Which debt securities do professional investors prefer?
Professional investors normally prefer convertible preferred stock or convertible debt. When convertible debt is used, it typically has a maturity under seven years and is unsecured, because the company seldom has hard assets to pledge as collateral. Although these securities may be more attractive to investors and assist in raising capital for the startup or early-stage corporation, they can leave a corporation with a difficult capital structure to manage as the company matures or needs additional financing.