Of all the troubles facing InvenSense (NYSE:INVN) today, debt seems to be the least of its concerns. At first glance, the terms of its convertible notes, issued last November, indicate a good deal for InvenSense -- a principal of $175 million, an interest rate of 1.75%, and a complex hedge transaction that protects shareholders from the bugaboo of dilution. Alas, for reasons that are detailed below, the terms are in fact quite unfavorable for the sensor maker.

Accounting for the convertibles

Normally, InvenSense's balance sheet would have shown, back on March 30, long-term debt of $169.3 million, net of issuance costs, whether the debt was convertible or not. But through a quirk in accounting rules, InvenSense is allowed to record part of that as equity so long as it retains the option of paying off the debt in cash and not stock upon conversion. And to protect the interests of its shareholders, InvenSense has heroically pledged to pay its creditors in cash at least up to the principal amount. This allows it to record long-term debt of roughly $139 million, based on a market rate of 7.3%. The difference is assigned to equity and is amortized until maturity arrives on Nov. 1, 2018.

Now, if the debt is ever converted into INVN shares -- which is most likely if the shares are trading at a premium to the conversion price of $21.89 -- the $175 million in cash would not be enough then to pay off the creditors upon conversion. There is that premium that must be paid, and to do this, InvenSense conducted a hedge transaction.

This is typically done by first buying a call option with an exercise price equal to the conversion price of the convertible debt, which in this case is $21.89. This would effectively pay for any amount above the principal of $175 million in the event of conversion. InvenSense then sold a call option on its stock with a strike price unlikely to be reached, which it figured to be $28.66. The combination of these two call options effectively raises the conversion price from $21.89 to $28.66. For this privilege, InvenSense paid a net debit of $13.5 million.

Why the terms of its debt are so unfavorable to InvenSense

On the surface, all of this seems very intelligently conceived. A low interest rate, a high conversion price, and no dilution -- what can be the problem?

The issue is not the interest rate but the principal, and the time to maturity, for on Nov. 1, 2018, InvenSense must stand ready to pay off a whopping $175 million.

I need not go into the various afflictions that have struck the sensor maker as of late. All of these factors, from the operating losses to the compressed margins, has created doubt as to whether InvenSense can pay off its creditors without doing significant damage to its shareholders.

Then there are the redemption rights, of which InvenSense has none. The typical issuer of convertible debt will retain the right to redeem. In fact, for the buyer of convertible debt, this call option held by the issuer is one of the main drawbacks of this hybrid security. It has the effect of putting a cap on the market price of the convertible debt, making it easier for the issuer to refinance, or forcing the creditors to convert to shares.

Not only did InvenSense relinquish this card, but it also gave its creditors two fresh ones, which would allow them to sell (or put) their debt to the issuer on two rare occasions: first, when the stock price reaches 130% of conversion price (during certain times) and, second, when the trading price of the convertibles falls below 98% of their conversion value (again at certain times). I won't go into the details of these terms, except to say that the probability that conversion will take place, while not zero, is unlikely. These options exist not to be used but to serve as price floors, and they reveal who most likely is the customer of this particular convertible issue -- arbitrageurs, mostly hedge funds, who buy the convertibles and short the stock. This may account to some extent for the relatively high short interest on INVN stock, and to a lesser extent for the fall in INVN stock since the issuance of its debt.

Most companies issue convertibles because they can't issue regular long-term debt. But there are securities such as Amazon.com's (NASDAQ:AMZN) convertibles, issued in 1999 -- 10-year maturity notes with favorable redemption features -- and there are convertibles like InvenSense's, with a five-year maturity and unfavorable redemption features. For equity holders at the very bottom of a company's capital structure, a convertible note like InvenSense's is worrisome. Indeed, I would argue that a convertible note structured like InvenSense's is more dangerous for the shareholder than even a secured note of greater seniority. The further south the fortunes of InvenSense go, the more likely we see a transfer of value from the equity holders to the convertible arbitrageurs.