What are convertible senior notes? How MicroStrategy uses them to buy Bitcoin

Convertible senior notes, explained

As someone who has spent years navigating the complex world of finance, I must say that MicroStrategy’s strategy of using convertible senior notes to fund Bitcoin purchases is nothing short of intriguing. Having seen my fair share of financial innovations, this approach certainly stands out as one that combines traditional debt and equity instruments with a highly volatile digital asset.

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. 

Essentially, a convertible senior note functions as a loan for investors, allowing them to exchange this loan for shares in the issuing company’s common stock. However, you may find yourself questioning the term “senior” – it signifies that if the company goes bankrupt, these notes have priority over other debts when it comes to repayment.

As a crypto investor, I’ve learned that when a company I’m invested in faces bankruptcy, being a holder of senior notes gives me an advantage. This is because, compared to other types of debt holders such as junior note holders or those with unsecured debt, I am prioritized in the repayment process.

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? 

Holders of convertible senior notes have an opportunity to be part of a company’s expansion by converting their notes into shares, which can make these investments more appealing compared to conventional debt. Given that they represent debt with a predetermined interest rate and expiration date, investors are shielded from potential losses.

How convertible notes work for Bitcoin investments

In different scenarios, convertible notes serve as a versatile funding method – even in the realm of Bitcoin investments.

MicroStrategy is widely recognized as a company that has heavily utilized convertible notes for financing its Bitcoin (BTC) acquisitions.

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).

Have you heard? MARA Holdings secured a $1 billion funding through the sale of zero-coupon convertible bonds. This strategic move enables them to amass Bitcoin without needing to pay any interest until the due date.

How MicroStrategy uses convertible senior notes to fund Bitcoin acquisitions

MicroStrategy, founded by Michael Saylor, has opted for a tactical move that includes selling convertible senior notes as a means to fund their substantial purchases of Bitcoin.

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 November 20, 2024, MicroStrategy revealed the terms for a $2.6 billion issue of non-interest bearing senior notes maturing in 2029. Notable aspects of this offering are as follows:

• 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 method has significantly benefited MicroStrategy, as the company managed an impressive annualized return of 80% from 2020 to 2024 – a feat that even surpassed the performance of Bitcoin itself. From mid-2020 onwards, MicroStrategy outperformed all major US stocks, such as Nvidia, largely due to its unique strategy of amassing Bitcoin.

Since last August, MicroStrategy’s stock value has skyrocketed more than 25 times (2,500%)! Meanwhile, Bitcoin has seen a staggering increase of approximately 660% in the same period. This remarkable growth emphasizes how Bitcoin’s price surge has played a substantial role in MicroStrategy’s market triumph.

Keep in mind that this company’s approach comes with a greater level of instability and risk due to its strong connection to Bitcoin’s future development prospects.

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

Companies find convertible senior notes attractive because they offer an efficient method for raising funds, preserve flexibility, and reduce immediate share 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

Although MicroStrategy mitigates financial risks using a blend of debt and equity instruments, it’s important to note that this investment strategy isn’t entirely 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.

Essentially, whether MicroStrategy’s approach of utilizing convertible senior notes for substantial Bitcoin investments will be sustainable in the long run depends on a combination of financial theories and the wider economic environment.

For those investors unsure or disagreed about keeping a volatile asset in their portfolio, the risk is significantly high. To maintain longevity, it’s crucial for firms to employ a well-balanced strategy, combining thorough market research, effective risk mitigation tactics, and adaptable financial planning.