Key Takeaways

  • Convertible debt allows startups to raise capital without immediately setting a valuation.
  • Key features include principal amount, interest rate, maturity date, and conversion terms such as discounts and caps.
  • Investors benefit from downside protection (repayment if no equity event) and upside potential (conversion to equity).
  • Common uses include seed financing, bridge funding, and aligning investor-company interests before valuation.
  • Risks involve dilution, uncertainty about valuation, and potential misalignment between founders and investors.

Debt conversion involves the money that an investor puts into a company with the intention of converting it into equity at a later date. Convertible debt is very common for startup companies.

What Is Convertible Debt?

Convertible debt functions similarly to normal lending, with one major exception. With convertible debt, the debt will eventually turn into equity for the issuer after certain conditions have been met. A company in its earliest stages may use convertible debt for fundraising purposes.

For instance, during a convertible debt round of fundraising, the owner of a company can raise capital without completing a company valuation. Instead of setting a valuation, a conversion discount or a valuation cap will be used. Unlike other financing rounds, convertible debt rounds can last for an extended period of time, giving investors more opportunity to put their money into the company.

Advantages and Disadvantages of Convertible Debt

Convertible debt provides a middle ground between equity financing and traditional loans. For startups, it enables raising funds quickly without the complexity of valuing the company at an early stage. Investors benefit from receiving interest on their notes while retaining the option to convert into equity later, often at a discount.

Advantages include:

  • Speed and simplicity: Easier and less costly to execute compared to priced equity rounds.
  • Deferred valuation: Allows startups to postpone valuation until they have more traction.
  • Investor incentives: Discounts and caps reward early risk-taking.
  • Flexibility: Can bridge the gap between funding rounds or serve as temporary financing.

Disadvantages include:

  • Potential dilution: Founders may face significant equity loss at conversion.
  • Debt pressure: Notes carry maturity dates and repayment obligations if no conversion event occurs.
  • Uncertain terms: Conversion mechanics can create complexity and disagreements.
  • Risk of overhang: Large amounts of convertible debt may discourage new equity investors

Convertible Debt Features

Convertible debt has a variety of features that you should understand. First and foremost, there is the principal amount, which is the total amount that an investor has invested in a company. The principal amount is listed on the convertible note. Most convertible debt has an interest rate. Interest rates for convertible notes accrue annually for as long as the note is outstanding.

Some notes have a compounding interest rate. This means that the interest regularly converts into principal, which then accrues additional interest. Other convertible debt have a simple interest rate. Your company will need to decide how you will pay accrued interest on convertible notes. The most common option is to pay the interest during debt conversion. You could also decide that compounding interest will convert into company shares instead of principal.

While interest rates for convertible notes used to be between 6 and 10 percent, an interest rate of 1 to 2 percent is now common. There can be serious tax and accounting implications if you state that your company's convertible notes will not accrue interest. Before accepting convertible debt, you should negotiate an interest rate with your investor.

A maturity date is another important feature of convertible debt. The maturity date is the date when the debt must be repaid. Many convertible notes include repayment options that are beneficial to the investor. For instance, the investor holding the note could decide to receive stock in the company instead of monetary payments when the maturity date arrives.

One of the main purposes of a maturity date is to set investor expectations, particularly as they relate to when the equity round will close. Companies typically prefer a later maturity date because it gives them more time to repay the note.

Conversion terms are the most important feature of convertible debt. In most cases, the principal amount listed on the convertible note is converted into capital stock when the company that issued the note reaches its next round of financing.

There are three issues that can have an impact on debt conversion:

  1. Qualified financing: Generally, equity financing will not cause debt conversion to occur. The exception is if the financing round raises a certain amount of money. The amount that will trigger conversion is usually one to two times the principal amount. This minimum amount allows the person holding the note to optimize their return on investment.
  2. Conversion discount: Some convertible notes include a conversion discount that is meant to make up for the risk assumed by the noteholder. The holder of a convertible note may receive a discount of between 15 and 25 percent on the company's equity relative to later investors.
  3. Conversion cap: Eventually, it's possible that the discount conversion won't be enough to make up for the noteholder's assumed risk. For instance, this can occur when an equity round causes the note to convert and the company has received a high valuation. To make sure the noteholder is compensated, the note can include a conversion cap. This cap guarantees that the person holding the note will receive maximum value upon conversion. A conversion cap can act as a valuation proxy.

Depending on how and when a note converts, the investor may receive something known as a "liquidation windfall." This occurs when debt conversion results in the noteholder receiving deeply discounted preferred stock, meaning that the amount of money that they may receive if the stock is ever liquidated would not reflect their original investment.

Common Uses of Convertible Debt

Convertible debt is especially common among startups and small businesses that need flexibility in early fundraising. Situations where it is frequently used include:

  • Seed financing: Early-stage companies raise capital without undergoing a full valuation.
  • Bridge funding: Used to extend runway before a larger equity round closes.
  • Strategic investor entry: Allows investors to participate quickly while deferring negotiations over valuation.
  • Risk mitigation: Provides investors with protection if the company fails, since debt holders have repayment priority

Risks and Considerations

While convertible debt is useful, it carries important risks. From the startup’s perspective, accumulating too much convertible debt may lead to unfavorable dilution when notes convert. For investors, the lack of clarity around the company’s future valuation can make it difficult to predict the return on investment.

Key considerations include:

  • Maturity date pressure: If no equity round occurs, repayment obligations may burden the company.
  • Valuation cap disputes: Misalignment may arise between founders and investors on how much equity should be issued.
  • Overhang on equity rounds: Large outstanding notes can complicate future fundraising and discourage new investors.
  • Tax and accounting implications: Convertible notes must be structured carefully to avoid unexpected liabilities

Convertible Debt vs. Equity and Traditional Loans

Convertible debt blends features of both equity and loans but differs from each in key ways:

  • Compared to equity financing: Convertible debt is faster and cheaper to arrange, but it defers rather than avoids dilution. Equity financing provides permanent capital without repayment obligations but requires negotiation of a company valuation upfront.
  • Compared to traditional loans: Convertible debt does not require immediate repayment if an equity round occurs, making it less risky for startups. However, unlike loans, it converts into ownership, giving investors potential upside if the company grows

Frequently Asked Questions

1. Why do startups use convertible debt?

Startups use convertible debt to raise funds quickly without setting a valuation, often during early or bridge financing rounds.

2. What happens if a company cannot raise equity before maturity?

If no equity round occurs, the company may have to repay the principal plus interest, unless renegotiated with investors.

3. What is a conversion discount?

A conversion discount gives investors equity at a reduced price compared to later investors, compensating them for early risk.

4. What is a valuation cap?

A valuation cap sets the maximum company valuation at which debt converts, protecting early investors from excessive dilution.

5. How does convertible debt differ from traditional loans?

Unlike traditional loans, convertible debt often converts to equity instead of being repaid in cash, giving investors upside potential if the company succeeds.

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