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.

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.

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