'Conversion Discount' is explained in detail and with examples in the Corporate Finance edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Conversion Discount refers to a special option applied to conversion investments. Understanding what a conversion is first becomes necessary in order to make sense of the discount clause. Conversions are the abilities to exchange some from of a convertible debt instrument into another kind of asset such as company stock. This conversion will be contractually spelled out at a prearranged price for a pre-set date deadline. The feature of a conversion itself proves to be a financial derivative type of instrument which has a separate and distinct value from the security itself. This is why including a conversion option in a security will only increase its all around value to the potential buyers.
Convertible bonds are excellent examples of assets that go through conversions and may end up with these discounts. Such a bond provides the holders with the ability to trade in the bond for a previously arranged quantity of stock in the company which issued the bond. This would usually be attractive to the holders of the bonds when the stock shares’ value is greater than that of the bond itself. This is the point when most bond holders choose to exercise their conversion clause.
Looking at a tangible example helps to clarify the issue. Consider that Paul has a convertible bond from Astra Zeneca the Anglo-Swedish pharmaceutical company. The bond has a value of $1,000. Should Paul have the option to convert this bond into 10 shares of Astra Zeneca stock, then he will probably choose to do so only if the stock is worth more than $100 per share. This would give him equity holdings greater than the $1,000 original value of the company bond.
The idea becomes interesting with discounts. The interest rates on such bonds is often very low, even less than five to six percent. This does not fairly compensate investors for the risks they often take on with companies that have non-established track records, insecure income streams, or shaky credit. Because of this, investors can be additionally compensated with the option to convert the note into equity. Once upon a time in the early years of the 2000’s, companies used to set this up as a stock warrant. In the last ten plus years they have been using conversion discounts with these notes instead.
Conversions discounts are quite attractive for investors. They do not simply deliver an options to buy a stock at a given time in the future as warrants do. Instead, they provide the right (but usually not the obligation) to convert into the stock at a lower price for every share (compared to other buyers) in a certain Qualified Financing event of the convertible notes. Naturally the investors’ benefits in this are far more instantaneous than with warrants. They are not required to wait for a company sale in order to buy more shares. They also receive these shares instead of having to buy them all over again, as with warrants. This means that no exercise price applies. This conversion discounted price for shares actually pays the cost of the additional shares which they are provided in the round of Qualified Financing.
As a result, they are getting more shares for their money. This is because the conversion discount is commonly 20 percent to 40 percent or even higher. As a concrete example, if the holder of a conversion note in the Cancer Cure Company offers the conversion discount at 30 percent, then for every seventy cents of the note the bond holder owns, he will receive a dollar face value share of stock.