Key Takeaways:

  • Convertible Debt Overview: Convertible debt allows a company to borrow funds with the intention of converting debt into equity at a future date, providing both initial liquidity and potential ownership stakes for investors.
  • Convertible Bonds: These are a form of convertible debt, often chosen to keep market perception stable while providing investors with both interest payments and potential future equity.
  • Importance to Startups: Convertible debt is valuable for startups needing capital without the immediate complexities of equity issuance, often appealing to investors due to potential high returns tied to the company’s growth.
  • Advantages & Risks: Convertible debt offers advantages, including deferred interest payments and reduced initial legal complexity. Risks include potential dilution of shares and complex loan agreements that require legal oversight.
  • Mechanics of Convertible Debt: Typically involving rounds of funding, investors may gain additional equity benefits, such as discounts or warrants, enhancing their returns as the company grows.
  • Market and Valuation Terms: Convertible debt agreements often include a valuation cap or discount, terms that define the price of shares upon conversion, impacting investor returns.
  • Convertible Debt vs. Equity: Choosing between convertible debt and traditional equity impacts both investors and founders in terms of dilution, flexibility, and legal costs.

Convertible Debt: What Is It?

Convertible debt is a loan or debt obligation from an investor that is paid with equity or stocks in a company. Convertible debt is also known as convertible loans or convertible notes.

When a company borrows money from investors and plans to convert it to equity or ownership in the company at a later time, that's convertible debt. The borrower and lender decide the type of equity and a set time when the loan converts based on the company's value when the loan begins.

Convertible Debt Benefits and Challenges for Early-Stage Companies

Convertible debt offers several distinct advantages for early-stage companies that may lack a credit history or sufficient collateral for traditional loans. By utilizing convertible debt, startups can access critical funding without establishing an immediate valuation, which might be challenging or even counterproductive at early growth stages. However, startups must weigh these benefits against potential challenges:

  • Advantages:
    • Lower Initial Costs: Convertible debt typically has lower upfront legal and administrative expenses than traditional equity fundraising.
    • Investor Appeal: The conversion feature provides investors the potential to gain equity in a successful company, making convertible debt an attractive option even for high-risk startups.
    • Flexible Structure: Convertible debt can delay the dilution of ownership until a later funding round, aligning better with company growth stages.
  • Challenges:
    • Potential Dilution upon Conversion: The conversion of debt to equity, especially in subsequent funding rounds, may dilute existing owners’ stakes.
    • Complex Agreements: Drafting a convertible debt agreement can be legally complex, often requiring experienced legal assistance to establish clear terms for conversion rates, caps, and discounts​.

What Is a Convertible Bond?

A convertible bond, or CV, is a type of debt security (like stocks) that's converted to an amount of company equity that the investor and company agree to at the bond's issue.

Companies may issue bonds to keep investor concern about company actions low. For example, if a company with shares in the stock market issues stock, the market sees that as a sign the company believes the stock is worth more than it really is. To keep the market from doing this, companies issue convertible bonds, which bondholders, or the investors, can convert later on.

Companies issue convertible bonds because investors want their money protected if the company fails or succeeds. For example, a company takes a risk with a product and loses money, but later gains huge success. The investor is still protected for part of the first bond, but also for the equity when the company succeeds.

Companies use convertible bonds to help lower borrowing costs. Convertible bonds have value added into them because they're basically bonds with stock options. In the end, investors make interest on the bond's original amount.

If a company issues a $1,000 convertible bond with 4 percent interest, that's convertible to 100 shares of stock 10 years later. Nine years later, the investor gets $1,040 if the bond isn't converted to stock:

  • Bond amount = $1,000
  • Interest (4%) = 40: $1,000 x .04 = 40
  • Total payment = $1,040

If company shares are trading at more than $10, the investor would benefit more from stock conversion. For example, if the company's stock is trading at $15 a share, the investor would make $1,500.

  • One share of stock = $15
  • Stock converted = x 100
  • Total = $1,500

Types of Convertible Debt Instruments

Convertible debt can take several forms, each with unique features and conversion mechanisms that impact both the company and the investor. Common types include:

  1. Convertible Bonds: Traditional debt instruments that allow investors to convert their bonds into shares of company stock at a later date, often linked to stock performance or specific triggers.
  2. Convertible Notes: Typically used in startup financing rounds, these are short-term loans that convert to equity upon a qualifying event, like a future financing round.
  3. Convertible Debentures: Similar to bonds but often unsecured, providing flexibility for companies that may not have significant collateral​.

Why Is Convertible Debt Important?

Startup businesses don't have credit ratings yet or proven history. Getting financed at a bank in nearly impossible without these things. This is why convertible loans are important; they allow businesses to get the starting capital needed based on the future success of the company. Because investors want their investments to make money, they're more likely to do what it takes to help the company succeed. The more success the company gains, the bigger profit the investor makes.

Convertible Debt in Market Volatility and Company Lifecycle

Convertible debt can play a strategic role in managing market volatility. By deferring equity issuance, companies can avoid exposing themselves to market reactions that might undervalue their potential. Additionally, convertible debt is beneficial across various company lifecycle stages, from early growth to pre-IPO phases, providing flexible funding options.

Convertible debt is particularly valuable in volatile markets, as companies can provide debt with equity potential without immediately impacting share prices, thereby maintaining market stability​.

Reasons to Consider Not Using Convertible Debt

Convertible loan agreements are complicated documents that lawyers should draft to protect the company and the investor. Law fees are costly for a startup company looking for a loan.

One of the biggest reasons companies are hesitant to use convertible debt is dilution. Dilution occurs on conversions when other investors besides the original investors begin buying shares of stock. When a loan converts before the next round of investments starts, investors lose a percentage of their share in the company.

Reasons to Consider Using Convertible Debt

Since convertible loans are part debt and part equity, investors earn interest on the total loan amount over the term of the loan. In most cases, the interest is added to the principal each month, and not paid each month. Startup companies don't have a monthly bill to pay this way.

Convertible notes are quicker and cheaper from the start than issuing equity. Convertible debt contracts created by lawyers, take weeks instead of months. Interest isn't paid every month. Existing investors don't lose as much equity after a new investment. Dilution is less likely to occur because profit from the conversion is used to increase company value.

Because convertible loans often have warrants or discounts, investors receive an added bonus at conversion. They make more money than just the interest on the principal. The choice to buy discounted or additional stock can net large profits.

Convertible Debt vs. Other Financing Options

Compared to other forms of financing, convertible debt offers advantages in balancing investor risk and reward, aligning well with both conservative debt holders and growth-focused equity investors. Here’s how it compares:

  • Convertible Debt vs. Equity Financing: Convertible debt typically involves lower initial dilution and allows for delayed equity issuance, whereas equity financing immediately impacts ownership distribution.
  • Convertible Debt vs. Traditional Loans: Unlike traditional loans, convertible debt doesn’t require immediate repayment, making it more suitable for cash-constrained startups. Convertible debt also converts into equity rather than requiring repayment, providing a flexible repayment method aligned with company performance.

How Convertible Debt Works

Investment works in cycles of loaning money and cashing out. Each cycle is considered a round. Companies often enter into another round with the same or another investor after debt converts. Companies can go through many rounds of investing and converting over the life of the business.

Sometimes a warrant or discount are terms of a convertible loan. Sometimes there's a limit on the value of the debt when it's converted. These terms apply to a single round of investments.

For example, a company needs a convertible loan for $500,000. If this loan has a warrant of 20 percent, the investor will gain a percentage of the note in addition to the original $500,000. At the start of the next round, the investor would receive $100,000 in securities (stocks, bonds, cash).

  • $500,000 x .20 = $100,000
  • Initial loan = $500,000
  • Warrant = $100,000
  • Total repayment is $600,000 in securities at the next round

Another convertible loan option is a discount; these are usually 20 or 25 percent. An investor offers the same $500,000 convertible loan, but with a 20 percent discount. When the loan converts at the end of the round, the investor can buy stock at a 20 percent discount. If shares are selling for $1, the investor can buy shares for .80 (1 x .20 = .80). Instead of only being able to buy 500,000 shares at $1, the investor can buy 625,000 at .80. When the 625,000 shares sell for $1, the investor gains a profit of $125,000.

Convertible notes often have a cap or limit to the total amount an investor receives at conversion. Caps are different because the investor and company must agree on an estimated company value when the negotiating the loan. In this example we'll use the same $500,000 convertible loan, but this time with a $10 million valuation and a $5 million cap.

At conversion, shares are given value by dividing the cap by the estimated value:

  • $5 million/$10 million = .50 per share

Now, the original note of $500,000 is divided by the share value:

  • $500,000/.50 = 1 million shares

When the investor sells the shares at the $1 market value, the profit is $500,000:

  • 1 million shares at $1 = $1 million
  • Initial investment = $500,000
  • Profit = $500,000

What Could Happen When You Do Convertible Debt vs. When You Don't Do Convertible Debt?

When a company chooses convertible debt, dilution is less because the company value usually goes up. Without setting an initial valuation, investors and companies are generally more fluid in negotiating loan terms. If a business doesn't succeed, debts get paid before equity. Investors like options that are less risky.

Companies that don't choose convertible debt spend more money in the beginning. It's unlikely that brand new companies would get a traditional loan, so the other option is equity borrowing. Equity borrowing requires lengthy contracts that take months to write. Lawyers' fees are expensive. If a company were to get a traditional loan, payments become due, even if the business isn't doing so great.

Key Terms in Convertible Debt Agreements

Understanding key terms is crucial for both startups and investors in negotiating effective convertible debt agreements:

  • Valuation Cap: A valuation ceiling set in the agreement, limiting the share price upon conversion to provide additional protection for investors in high-growth scenarios.
  • Discount Rate: The agreed-upon discount on the conversion price that gives investors an equity bonus, incentivizing early investment.
  • Conversion Trigger: Specific events or conditions (like subsequent funding rounds) that automatically convert the debt to equity.
  • Interest Accrual and Payment: Most convertible debt instruments accrue interest that is paid upon conversion rather than monthly, easing early cash flow demands on startups​.

By structuring these terms carefully, companies can attract investors while maintaining flexibility for future growth.

Frequently Asked Questions

When does convertible debt become equity?

Convertible debt usually turns into stocks when company income reaches a certain level or at a certain time. Both parties decide on terms during negotiations.

When should companies use convertible debt?

Convertible debt is best for startup companies that don't have a history yet. It's also a good option for companies in between investing rounds.

What are warrants?

Warrants are options in convertible loan contracts that give the investor a guarantee of additional stocks in the next investment round. Warrants are based on a percentage of the original loan amount.

How do convertible discounts work?

A discount is another option in the loan contract. Discounts guarantee investors a lower stock price than public pricing when the loan converts.

If you need help with convertible debt, you can post your question or concern on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.