Can Private Corporations Issue Convertible Bonds?

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.

What Is a Private Company?

The first step to answering the question of whether a privately owned company can issue such securities is to define 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 strict filing requirements of the Securities and Exchange Commission (SEC) for public companies.

In general, these businesses' shares or debts 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 bond 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.

The Bottom Line

Privately held companies cannot issue traditional convertible bonds because they do not have publicly traded shares for conversion. However, they can use convertible notes as a substitute to raise capital.

Convertible notes allow for a conversion to equity in the company, which is a good option for startups, small businesses, and other privately held companies. Because there are no public shares in this arrangement, these types of notes are usually less liquid and more complex than regular convertible bonds.