A savvy reader sent me an email about my post, Convertible Debt:  Delaying Valuation.  I thought our exchange was worth sharing.

He wrote: I saw your comments on convertible debt and had a couple of questions for you about a convertible note with a “mandatory” conversion:

• The investor insisted upon a mandatory conversion after three years. Why would he want to give up his option to convert and instead, make it mandatory?

It is common for there to be a forced event after a defined time period – otherwise the noteholder could be stuck holding a non-interest paying asset forever (in theory). To my knowledge there are two types of common events triggered after a defined time period: conversion or payback. I believe that it’s more common for a payback to be stipulated since failure to raise more capital often implies a failure of the company to live up to the expectations at the time of lending. If the company fails, the noteholder will want to remain a debtor so that they have first pick at the company’s assets.

I understand the point that you make about having the option to convert. I am under the impression that most notes don’t permit the conversion to happen subjectively – they are event driven (e.g., financing, time period). To your point, a better play for this investor would be to have the option to convert-at-will after a pre-defined period, giving them the option to remain a debtor if that is advantageous at the time. This enables them to maintain downside protection.