This is the REAL deal, you think to yourself. You’re ready to move forward and make your idea a reality, but you just need the money to make it happen. You’re getting ready to approach investors, and you need a plan. You confide in a friend, who tells you to think about “convertible debt” – what’s that?
If you’re an entrepreneur looking to grow your startup, this article is for you. If you’re an investor who’s been presented with a convertible note, you may want to check out our post on Convertible Notes for an investor-based perspective.
This article will cover some of the key questions you’re probably thinking about:
There are 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, and usually with interest. Debtholders typically don’t get a say in how you run your company. When you sell equity in your company, you can raise money that you don’t have to pay back. But, you have to give up some ownership and control when you sell that equity.
It can be hard to get funding; few people want to risk giving money to a new company. Banks may turn you down, and investors may say no to buying equity from you. So what can you, or investors who want to take a chance on you, do? Enter: convertible debt.
Convertible debt, which takes the form of a convertible note, is a financial instrument that starts off as a loan, and changes to equity down the road.
To see how convertible debt might work, let’s look at a fairly simple scenario. Let’s say you need to raise $10,000 so you can make widgets (or shoes, or beer, or whatever your company sells). 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 in a later round of funding. Also, because he’s one of the first people to invest in your idea, he wants a 20% discount. In other words, he gets to pay 20% less than what a future investor will pay for the same shares in a later round of funding.
You agree. Things go well, and a year later, you have a successful Series A round of funding 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 12,500 shares. Not bad.
While convertible debt might seem like a simple solution to the debt vs. equity dilemma, that’s not always the case. Many convertible notes will have special features, such as valuation caps, floors, puts, calls, and other terms that might make the transaction more complicated. Even the simplest convertible notes need to have clear contract terms. 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 notes are a great way for startups to access relatively quick loans with low interest rates from private investors. Also, many early stage investors like convertible debt because it can be a win-win for them: if your company succeeds, the investor can convert a loan into a more valuable ownership stake; if the company tanks, the investor can still get some of their money back. So, convertible debt can be an excellent springboard to launch your business to the next level.
Updated: 06/28/2019 by Shamila Ahmed.