WHAT IS CONVERTIBLE DEBT? Convertible debt is a loan that can be converted to equity. The borrower issues a convertible promissory note to the investor for a limited term, usually one or two years. When the note matures, the investor may cash in the note with interest, or he can convert the note into capital stock of the borrowers company.
WHEN DOES CONVERTIBLE DEBT CONVERT TOEQUITY? Convertible debt typically converts to equity the next time your startup raises capital (think venture capital or similar large investor). Technically, this large raise is called a “qualified financing” per the convertible debt agreements (note and note purchase agreement).
How does convertible debt convert to equity? Convertible debt converts to equity based on the valuation your startup receives from the venture capital firm in the “qualified financing.” For example, if your venture capital investor ends up paying $1 per share for your startup’s preferred stock and you have $800,000 of convertible debt, the investor will receive 800,000 shares of preferred stock. The loan will then be cancelled. (Note: Convertible debt often converts to preferred stock at a discount than what the venture capital investor pays for the preferred shares.)
What are its advantages? Easy For Startup Businesses to Acquire If youre starting a brand new business and having a hard time finding a bank to finance your venture, convertible debt may be an option. Convertible debt financing is cost effective and eliminates much of the legal complexity of traditional equity financing. It is often easier for start-up companies to find a lender willing to perform convertible debt financing, because the lender has less to risk.
Money without a Valuation Convertible debt allows a new business to get necessary investment funds without setting a valuation on the company before institutional investors enter the picture. Because new business owners tend to overvalue how much the business is worth, convertible debt gets rid of the risk of a down round, which is an investment round where a share price is lower than in the previous round. This is convenient if your family and friends are helping finance your new business, because they would likely be discouraged by institutional investment offers that are much lower than what you anticipated.
Investor Advantages In a convertible debt agreement, investors are viewed as creditors of the start-up business. This is advantageous if the company liquidates or goes bankrupt. Note holders are shown preferential treatment when the companys assets are divided. As the note is secured against the borrowers assets, an investor may feel more secure lending using convertible debt than he would through a traditional bank loan.
What are its disadvantages? In the event that the convertible promissory comes due and it is not converted to equity or stock, the note still remains payable when the lender calls it in. The note is taken out against the companys assets, and the lender has the right to liquidate the assets to get his money. This can put a company in dire financial straits.