Convertible debt (also called a convertible note) is a way for businesses and startups to inject capital into their operations. It’s typically in the form of short-term loans that are repaid with cash, and the remainder is converted into equity. There are many financial and legal implications associated with convertible debt, so it’s crucial to understand what it is, how it works, and the benefits and disadvantages.
We’ve got you covered with this complete guide to understanding convertible debt. Let’s start by talking about exactly what convertible debt means.
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Table of Contents
What Is Convertible Debt?
The easiest way to think about convertible debt is as a short-term loan that carries an issuance rate, date of maturity, and interest rate. Convertible debt is unique because it can be compensated with equity rather than cash.
Convertible debt was developed for startups to use before having a business valuation to raise capital faster than with other traditional methods. Investors typically offer startups a private loan with a contingency that the debt typically converts to stock ownership later on down the road.
These types of investors include:
- Angel investors
- Non-profit organizations
- Venture capitalists
- Specialty financial institutions
- Private investors
Convertible debts are a fast way for founders to get a loan and not worry about short-term payments for cash. Generally, convertible notes are favorable because startup owners get an inexpensive and fast injection of money that they can then exchange for equity. However, before accepting convertible debt to investors and venture capitalists, you need to ensure that you understand exactly how convertible debt works.
How Does Convertible Debt Work?
How convertible debt is structured primarily depends on the industry, parties involved, and the amount borrowed. There are some calculations the investors and startup founders can use to help determine how much equity or stock to issue during these transactions.
There are five elements that affect how many stock shares are provided in return for convertible debt:
- The company valuation at its time of maturity
- Any applicable conversion discounts
- The remaining convertible debt balance
- The number of issued and outstanding shares
- Any use of conversion caps for the loan
When using convertible debt, startups typically will issue their investor or venture capitalist a promissory note outlining the various terms and conditions of the transaction. Of course, it’s crucial to get these terms and conditions right, so startups might want to work with a venture capitalist lawyer to ensure their convertible debt deal does what they want.
Convertible Debt vs. Equity
Equity investments differ from convertible debts. In equity finance, an investor purchases stock from a company in a priced round, and that investment is typically a percentage based on the company’s current valuation. Typically, investors buy preferred stock shares that offer more privileges than common stock shares.
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So, instead of paying investors back with cash and the remainder converting into equity, it’s an equity investment for the investor, and the company gets its required capital to operate.
Establishing whether to raise capital using convertible debts or equity depends largely on the startup or business. Owners and founders should consider the different pros and cons of convertible debt before finalizing their decision.
Pros and Cons of Convertible Debt
As more business owners and founders turn to convertible debts to raise capital, there are both advantages and disadvantages to consider. Although it seems like a straightforward process, different deal structures can quickly become complicated. Understanding the nuances of convertible debt can help you and your company make a sound decision to support your longevity and success.
Consider these pros and cons of convertible debt:
- Typically, convertible debts are straightforward and uncomplicated in structure. However, these debts can also become extremely complicated if you go into numerous financing rounds.
- Pre-valuation investment processes come with many variables, and convertible notes allow business owners to defer those valuation negotiations until later.
- Some investors don’t like convertible notes because it can be challenging to determine whether or not the terms and conditions are fair to them. Investors are typically concerned about control, liquidation, voting, and pro-rata rights.
- Convertible debt holders have no way to influence their investment outcome directly.
- The biggest advantage of convertible debt for startups is how streamlined the process is; it can reduce costs, save time, and minimize priced round complexities.
There are various factors and circumstances that business owners, founders, investors should consider before entering a convertible debt agreement. So, finally, let’s look at common terms used in the convertible debt space to help you lay the groundwork to obtain capital and set your expectations for the process.
Convertible Debt: Terms to Understand
Convertible debt consists of several moving parts. These are the common terms that you should understand:
- Interest rates: while self-explanatory, convertible debt interest rates usually fall between 4 and 8%.
- Maturity dates: typically, convertible debts will mature within two years.
- Mandatory conversion: this term describes the minimum size of a pricing round that must close in the future and convert the debt to equity.
- Optional conversion: this is a provision that gives investors a chance to convert their remaining equity securities into another financing round even if it doesn’t meet the definition of qualified financing.
- Change of control: this addresses what happens if the company is sold before the debt note converts.
- Valuation caps: this term dictates the maximum pre-investment value that’s used to convert the note.
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The Bottom Line on Convertible Debt
When it comes to convertible debt for startups, it’s crucial to weigh all of your options with a professional. Doing so can help your company avoid making mistakes and raise more money for a better financial future. How you raise capital is a critical choice, meaning it’s essential to get it right from the start to protect your company’s performance and longevity.
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