By: Marie Smith

Business is booming, but it could be even better.  Mom already gave you some money to get started, but you ran through that pretty quickly.  You know your idea is great, but you just need cash to make it a reality.  You believe in your baby, and know she just needs the right food so she can grow. So how can you feed her?

Debt v. Equity:  Some Basics

There are basically only two ways to raise money for your business:  borrow cash (debt) or sell a part of your company (equity).  Taking on debt means you need to pay back the money you borrowed, usually with interest.  Debtholders typically don’t get a say in how you run your company.  On the other hand, selling equity lets you raise money that you don’t have to pay back, but you must give up some ownership and control.

But what if the bank turns you down, and those wealthy friends of yours laughed you off?  If you have a new company, it may be hard to get funding; few people want to risk giving money to a budding business.  So what can you, or investors who want to take a chance on you, do?  Enter:  convertible debt.

What is Convertible Debt and Who Wants It?

Convertible debt, AKA a convertible note, is a financial instrument that starts off as a loan and then changes to equity down the road.  Many early stage investors like convertible debt because it can be a win-win for them.  If the company succeeds, they can convert a loan into a more valuable ownership stake.  If the company tanks, they can still get some of their money back.  Startups are often willing to sign convertible notes because it allows them to access relatively quick loans with low interest rates from private investors.

How it Works

To see how convertible debt might work, let’s look at a fairly simple scenario.  You need to raise $10,000 so you can make more widgets (or shoes, or beer, or whatever you’re into).  Along comes Alex Investor, who thinks your new business will blow up if it gets enough funding.  He’s willing to lend you the money, but he wants to convert that loan into equity when you bring in Series A investors.  Also, because he is the first person other than your mom to invest in your idea, he wants a 20% discount.  In other words, he gets to pay 20% less than any Series A investor will pay for the same shares.

You agree.  Things go well, and a year later, you have a successful Series A raise with shares valued at $1.00 each.  The new investors pay $1.00 for their stocks, but Alex Investor only has to pay 80¢ for his.  For his $10,000 investment, he ends up with 12,000 shares.  Not bad.

Conclusion

If you found our quick little example complicated, I’ve got bad news for you.  Not every convertible debt deal is so easy.  Many notes will have special features, such as caps, floors, puts, calls, and other terms that you might not be familiar with.  Even the simplest convertible notes need to be clearly stated in a contract.  On top of that, there will likely be paperwork that needs to be filed with the government.  But don’t let this scare you off.  Convertible debt can be an excellent springboard to launch your business to the next level.  As they say:  “scared money don’t make no money.”

Marie Kym Smith

Associate Attorney

(212) 865-9848

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