A convertible note (a.k.a. "convertible bond") is a financial instrument that is a hybrid between debt and equity in a business. The way it works is that an investor invests some money in a company, called the principal. At some point (typically during a round of fundraising), the investment is converted from debt to common stock in the company. So instead of the debt being repaid in cash, it is discharged in equity. These notes are often issued in the early days of a company when an accurate valuation would be very difficult or impossible to determine, making it difficult for investors to purchase equity directly. Typically, there are a few ways the investor can profit from this arrangement, and I am wondering about the status of all of these factors with respect to the halakhos of ribbis:

Valuation Cap

The valuation cap of an investment is the maximum amount that can be considered the valuation for calculating the number of shares received upon conversion. For example, if a convertible note has a valuation cap of $4M and the company has a fundraising round with a valuation of $12M at $10/share, the note will convert to equity as if the valuation were $4M. So the investment will convert from debt to equity at a conversion factor of $3.33/share (i.e. 1/3 of the actual price per share).

Discount Factor

The discount factor is a percentage by which the share price is discounted at the time of conversion. If a convertible note has a discount percentage of 20% and the company issues shares at $10/share, the debt will be converted to equity at a rate of $8/share.

Typically, convertible notes will have both a valuation cap and a discount factor and whichever method provides the best result for the investor (i.e. the method that results in receiving the greatest number of shares) is the one that is used. Convertible notes may also have an interest rate.

Interest Rate

Similar to regular debt, the interest rate is the rate at which the principal grows in value before it is converted. For example, if the investment has a 10% interest rate compounded annually and a fundraising round is held exactly one year after the date on the note, a $10,000 investment will convert to equity with a value of $11,000.

All of the above factors seem like they could be problematic with respect to the laws of charging interest if the debt is between two Jews, especially the interest rate. On the other hand, perhaps because the debt is not discharged as repayment with interest, it would be permitted. What would be the din of convertible notes?

  • Are you looking for an authority’s ruling? A user’s understanding? – Dr. Shmuel May 29 at 17:52
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    @Dr.Shmuel Like any halacha question, the more authoritative the better. But logical reasoning is acceptable as an answer, especially if backed by halakhic sources. – Daniel May 29 at 17:54
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    Isn't it the essence of היתר עסקא? en.wikipedia.org/wiki/Loans_and_interest_in_Judaism – Al Berko May 29 at 17:54
  • @AlBerko Yes, it does seem very similar to heter iska, but I am not familiar with the exact mechanics of how it works – Daniel May 29 at 17:55

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