In the minds of most people, especially M&A novices, an investment comes in the form of equity — an investor buying stock in the company. This kind of investment makes the most sense when the company has publicly traded stock and the stock has a large-enough average daily volume to make the investment liquid.
But investments in private companies are highly illiquid because the shares don’t trade on a public stock exchange, so investors are wise to structure the deal in the form of convertible debt, debt that they can convert to equity, usually at the time of their choosing.
This way, if the company goes under, the investor gets repaid before equity holders, but she also has the option to covert her debt into to stock in the event the company goes public.
Why structure the deal this way? In the world of accounting, debt holders are higher up on the food chain than stock owners. Say a company has two investors: One person loaned $1 million to the company, and the other person owns 100 percent of the stock. If the company fails and selling the assets recoups $500,000, that money reverts to the debt holder, and the stockholder is wiped out.
On the other hand, if the company is wildly successful, turning the debt into stock can be quite lucrative. Say that same company sells for $25 million. As a debt holder, the investor gets her $1 million (plus any outstanding interest) back, but as a stockholder, she’d receive the remaining $24 million.
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Source:http://www.dummies.com/how-to/content/ma-transactions-structuring-equity-investments.html
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