A convertible bond is a debt that may be converted into a predetermined amount of the underlying company's common stock at certain times during the bond's life, usually at the discretion of the bondholder. Since private companies do not raise capital by issuing securities under the purview of the Securities and Exchange Commission (SEC), such firms cannot legally issue convertibles.
Note that investors in private companies, especially in the case of start-ups, may structure convertible notes that begin as debt obligations but then convert into an equity claim in the company. These notes, however, are not tradeable securities like convertible bonds and do not convert into common stock.
- Privately held companies do not fall under SEC regulation since they do not issue publicly traded securities.
- As a result, private companies cannot issue convertible bonds that are tradeable and which convert into common stock.
- A private company may, however, create non-tradeable convertible notes in order to raise capital from direct investors.
What Is a Private Company?
The first step to answering the question of whether a privately-owned company can issue such securities first requires defining the term "private company." Many times, the term "private" refers to a company that is either a sole proprietorship (one owner) or a partnership (a few owners). "Private" may also refer to a business that's actually incorporated under state laws, but which does not have stock that is traded on any exchange or by over-the-counter market makers.
Private companies may issue stock and have shareholders, but their shares do not trade on public exchanges and are not issued through an initial public offering (IPO). As a result, most private firms do not need to meet the Securities and Exchange Commission's (SEC) strict filing requirements for public companies. In general, the shares or debts of these businesses are less liquid, and their valuations are more difficult to determine.
Why Private Companies Cannot Issue Convertible Bonds
The main reason why private companies cannot issue convertible bonds has less to do with any laws against privately-held companies issuing bonds and more to do with the fact that no shares of stock exist into which to convert the bonds.
On the other hand, a closely-held subchapter S or C corporation, which does not trade on any exchange, theoretically may issue convertible bonds if allowed by its corporate charter and state laws. The feasibility of executing a bonds issue of this kind is another matter, however, because many closely-held corporations might have only 100 shares of stock outstanding, if not less.
It is not unheard of for an owner or local investor to lend smaller corporations money in the form of bonds that come with a convertible feature. However, this usually is carried out as a means of protecting the lender by permitting ownership in the company if it fails to repay the loan.