Convertible debt is one of the most common instruments used in early stage startup financing. At its core, it is a loan provided by an investor to a company.
However, unlike a traditional bank loan or mortgage, the intention is not for the company to pay back the principal plus interest in cash. Instead, the intention is for that debt to turn into equity at a later date.
This conversion typically happens during a future financing round, often called a Series A or a large Seed round.
The Mechanics of Conversion
#When an investor gives you money via convertible debt, they are giving you cash now in exchange for shares later. The number of shares they receive depends on the price of the shares in that future funding round.
To compensate the early investor for taking a risk on you before you had a proven valuation, the debt usually converts with specific advantages. These are the two main levers you need to understand.
The Discount Rate This gives the early investor a discount on the price per share compared to the new investors. If the discount is 20 percent and new investors pay one dollar per share, the convertible debt holder might convert their loan into shares at 80 cents per share.
The Valuation Cap This puts a ceiling on the valuation at which the note converts. If your startup creates incredible value and raises money at a 20 million dollar valuation, but the early investor had a 10 million dollar cap, their money converts as if the company were only worth 10 million. This grants them significantly more ownership for their early belief in your vision.
Why Use Debt Instead of Equity?
#You might wonder why a founder would use a debt instrument rather than just selling stock. There are distinct practical reasons for this.
Speed and Cost Drafting equity documents is expensive and time consuming. It involves lawyers and complex negotiations. Convertible debt documents are generally standardized and shorter. This allows you to close a round and get the money in the bank faster.
Delaying Valuation Valuing a brand new company is difficult. You might think it is worth 5 million, but an investor might think it is worth 2 million. Convertible debt kicks this can down the road. You agree to let the market decide the value later when you have more traction and data.
Comparing Convertible Debt to Priced Rounds
#A priced round is when you explicitly sell a percentage of your company for a set price. Everyone knows exactly what they own immediately.
With convertible debt, the capitalization table remains somewhat fluid. You know you owe money that will become shares, but the exact percentage is variable until the conversion event occurs.
Risks and Considerations
#While this instrument is useful, it is still technically debt. Convertible notes have a maturity date. If you fail to raise that next round of funding before the maturity date, the investors can theoretically demand repayment.
Most early stage investors will not force a startup into bankruptcy, but it puts you in a position of weakness where you may have to renegotiate terms.
You must ask yourself if you are comfortable carrying a liability on your balance sheet that has an expiration date. Does the speed of capital today outweigh the potential complexity of conversion tomorrow?