Convertible debt is a financing option that gives investors the right, but not the obligation, to exchange the value of their debt for equity on a set date or when certain events occur. Convertible debt offers investors and companies a high degree of flexibility, low ongoing costs, and a large source of funding.
What Is Convertible Debt?
Convertible debt is a form of financing that provides investors with an option to receive interest on debt payments or converting the debt to equity at a set price. It offers investors the upside benefit of equity financing, plus the downside protection of debt financing. Public companies and startups use convertible debt to raise money.
When Convertible Debt Is Used
Founders, startups, angel investors, and venture capital firms use convertible debt for different reasons. Startups and founders use this instrument to avoid early equity dilution and to raise funds before seeking venture capital funding. Angel investors and venture capital firms issue convertible debt to reduce their risk and provide seed money to startups.
Scenarios in which convertible debt is used include:
- Founders wanting to avoid equity dilution: To avoid giving away early control of the company, founders can use convertible debt to maintain their decision-making power at a startup while raising money and offering investors future equity. This also acts to strengthen their case for series A, B, C & D funding rounds.
- Pre-valuation startups needing to raise capital: Valuations of early-stage companies are complex and must be done by experienced investors and venture capital firms. Coming up with a valuation and raising venture capital can take too long for early-stage startups that need small funding amounts.
- Angel investors wanting some protection from downside risk: Convertible debt offers angel investors an opportunity to take part in the upside of a growing startup. Sometimes, this financing can also protect angel investors from downside risk, which can make it easier for startups to raise angel funding.
- Venture capital prospecting: Venture capital firms often use convertible debt while prospecting for new companies to both support the development relationship with founders. This benefits both parties because if the venture capitalist makes follow-up investments both parties already have a working relationship.
Although these scenarios are the most common use cases, there are other cases when convertible debt may be a good option. For startups, it extends the runways, or amount of time a startup can operate with its current cash, without monthly debt payments and they can use the funding as a type of bridge loan. Investors that issue convertible notes are better aligned with the companies they invest in than some traditional lenders are.
“Many startups use convertible notes as a ‘bridge’ between two rounds of equity financing, for example between a seed and a series A round. This approach is what makes the most sense for me since it can allow a founding team to focus on operations to reach the required business milestones for a successful series A funding event, with enough money in the bank and a well-defined cap table from the original seed round.”
How Convertible Debt Works
After pitching investors, founders often negotiate the amount of funding they need and prepare convertible debt terms. Investors and business owners negotiate the terms, which include factors such as dilution, valuation caps, interest rates, and trigger events. These terms influence the final cost of funding, so founders should take their time in reviewing the convertible note term sheet that investors present and ensure that they understand all the details.
Once founders reach an agreement with investors, they typically receive funds. Investors can then convert the debt into preferred stock at a future fundraising event. Investment and valuation by venture capitalists, private equity firms, or an initial public offering are the most common events.
Angel investors are often hesitant to provide an early stage valuation, due to the complexity of setting a value to the future potential of a company. By delaying conversion, startups can raise funds and investors can receive their premiums without burdening the startup with excessive debt payments and equity dilution.
Types of Convertible Debt
There are two primary types of convertible debt: bonds and notes. Both have similar structures with the major differences in the terms, maturity dates, and options that investors have to convert. When companies evaluate debt and equity financing, convertible financing is often the middle ground that provides the most benefit.
What Convertible Bonds Are
Public companies use convertible bonds to raise funding without surrendering immediate equity. Investors receive an option to convert their bonds into preferred shares at a specified value, either before or on an agreed-upon date. Convertible bonds are only available as a financing option for public companies.
What Convertible Notes Are
Startups and other businesses often use convertible notes to raise funding from investors in the early stages of development. Friends and family loans, angel investors, and venture capitalists provide this funding. Investors can also exchange convertible notes for equity, but the trigger is at a company valuation. The value of the convertible note depends on the terms of the note and the valuation.
Convertible Debt Costs & Terms
Convertible debt typically offers flexible terms that vary widely based on the investor, the company seeking funding, and the company’s stage in development. These terms include the fundraising amount, investment restrictions, discount rates, valuation caps, trigger events, and maturity dates.
Common convertible debt terms and costs include:
- Fundraising amount: The amount of funding that investors will provide in exchange for convertible debt. The more funding a company raises the more it will need to pay back in either debt or a percentage of equity. Therefore it’s important to raise only the funds that a company needs, rather than the maximum amount.
- Use restrictions: Any restrictions placed upon the founders or management of the company on the purpose for which businesses can use the funds. Although this has no direct effect on the costs, it can introduce soft costs like relocation if investors require a startup to relocate to a specific geographic region.
- Discount rate: The discount convertible debt investors receive at the next valuation round. For example, a $1 per share valuation with a 20% discount will enable the investor to purchase shares for $0.80 on the dollar. A high discount rate results in both the equity and debt costs increasing for the startup.
- Valuation cap: The upper limit of the future valuations that the investor will use for conversion into equity. Investors in the company with $2 million valuations and $1 million valuation cap will exchange shares based on the cap, receiving a 50% discount to the share price. This only influences costs if the valuation is higher than the cap.
- Interest rate: The debt portion of convertible debt sometimes carries an interest rate but borrowers typically don’t make regular debt payments. Instead, investors add this rate to the principal increasing the cost for the startup and the value that investors receive.
- Trigger events: Convertible notes have a trigger event when startups raise funds and receive a valuation. This is perhaps the most unpredictable portion of convertible debt, because valuation timing can have a large influence on the overall cost.
- Maturity date: Some convertible debt like convertible bonds have a maturity date. Investors have the option to convert to equity on this date based on the current value of shares and the size of their holdings. A maturity date is more predictable and leads to easier to estimate costs.
Convertible debt costs are variable and depend on several factors specific to the investor offering financing and the business receiving funding. Businesses can estimate the cost when they sign a funding agreement, but they won’t know the true cost until the trigger event for a convertible note. This is because the final cost depends on the company valuation at the time of conversion.
Convertible Debt Startup Funding Example
Startup founders that raise funding typically start with a fundraising amount in mind. In our example, a startup is interested in raising $100,000 in convertible debt from angel investors and venture capital firms. After finding and pitching angel investors, founders negotiate terms and receive funding.
The terms for our example include the fundraising amount, discount rate, valuation cap, and trigger event, which are all common with convertible notes. The startup in our example is raising $100,000 in convertible debt, with a discount rate of 20% and a valuation cap of $2 million. Its investors can exchange their debt for equity if the company receives a valuation from a third party like a venture capital firm.
If the startup is valued at $1 million at a price of $1 per share, the debtholder’s options include:
- Debt: $110,000 in one payment, calculated as the fundraising amount plus the added discount rate. $100,000 + ($100,000 x 20%) = $120,000.
- Equity: $125,000 in stock, calculated as the value of $100,000 in equity at a share price of $0.80. The share price receives a 20% discount $1 – ($1 x 20%) = $0.80. Then the note amount is divided by the discounted share price to produce the value of the equity $100,000 / $0.90 = $125,000.
We see that in this case investors are better compensated with equity, making it a good deal for both parties, but the valuation plays a large role in whether the transaction ends up being beneficial. However, the situation may be different if the company in our example exceeds its valuation cap.
Debt and Equity Cost of Convertible Debt Based on Valuation
This example leads to an interesting view of what impact a valuation cap has if it’s exceeded. With a $3 million valuation at $3 per share, the investor converts into the same number of shares that they would if the valuation was $2 million. However, the actual value of each share after conversion is $3, giving the investors a 50% increase in the value of their investment at the price of further dilution for founders.
8 Tips From Pros Who Helped Raise Convertible Debt
Convertible debt is a common instrument in startup fundraising, and entrepreneurs and financial professionals with extensive experience can provide insight into best practices and common pitfalls. According to them, entrepreneurs should avoid convertible debt with fees and overly favorable investor terms. It’s also important to come to an agreement, understand the contract, and invest the right time into fundraising.
Eight tips for raising convertible debt include:
1. Avoid Investors Who Charge Fees
There are some investors who charge startups money upfront for consulting or commissions to lead an investment round. Although there are brokers that can help startups raise funding, it is unusual for startups to pay fees to their investors.
“Stay away from investors who want to get paid outside of their investment. You shouldn’t have to pay consulting fees or commissions to an investor. They are rewarded as the value of the company grows.”
—Shaun Savage, Founder & CEO of GoShare
2. Select Investors Wisely
Unlike a traditional lender, most investors work with the companies they invest in to guide them toward success. Searching for investors can be a challenging task, but it’s important to select investors who also make good business partners. One of the best ways to do this is by ensuring that founders align their business goals with investors.
“Be selective and specific with the VC firms or angel investors you allow to receive a loan from—they will be present in your company down the road. Make sure these are the people you want to be part of your business.”
—Jared Weitz, CEO of United Capital Source
3. Understand What Might Prevent Funding
Business owners raising convertible debt need to understand the shortcomings of their businesses to successfully pitch investors. Those shortcomings are often the reason that the business needs capital. Being transparent about them and discussing them with investors sets founders off on the same foot and instills confidence in an entrepreneurs’ ability.
“Know where all your gaps are before heading into talks with investors. Put yourself in their shoes and seek out the flaws within your proposal and business that they are going to catch. When you walk-in already knowing what you still need to work on, it won’t be a shock when they ask about it. Plus, you will already have ideas and potential plans in place to make improvements—this will instill confidence in your potential investors that you mean business.”
4. Avoid Terms That Favor Investors Too Strongly
Convertible debt terms can vary and some founders get taken advantage of by more experienced investors. Founders should avoid terms that are overly beneficial to investors, especially if those terms have the potential to result in a large amount of ownership upon conversion. One of the best ways to mitigate this problem is to consult an investment banker or attorney when drafting up a contract.
“One thing to stay away from is what is known as a ‘death spiral.’ This reduces the conversion price based on later rounds of financing. Although this might protect the investor, it causes more dilution and is problematic for the company.”
—James Cassel, chairman of Cassel Salpeter & Co
5. Avoid Shopping Around for Too Long
Setting fair terms and ensuring that a startup does not run out of money should be a major priority for the founding team when raising convertible debt from investors. It’s tempting to shop around for the best deal, however, taking time away from the business and risking running out of capital is much more damaging than receiving average terms.
“The right thing to do is to negotiate fair terms. That means sometimes setting a ‘cap’ on the note—which means that your investors have some protection on the final valuation. Also, look for a sensible discount—typically the investor gets 15% or 20% discount on the next round priced level of financing. If your investor is asking for a low cap or a larger discount, that raises some red flags.”
—Jeb Ory, CEO, and co-founder of DC-based Phone2Action
6. Seek Out Conventional Debt First
“Initially, the startup should seek out the conventional debt, but often startups don’t have the collateral value or historical performance that most lenders look for from applicants. The next source of capital might be VC investment (or other equity investors).”
—Keith Chulumovich, Managing Director, O’Keefe, CPA
As Chulumovich explains, startup business loans are also an option and founders should explore those that cost the least first. However, it’s difficult to raise money through equity or traditional debt in the early stages of a startup. In that case, Chulumovich explains that convertible debt may be the best option.
“Convertible debt is a hybrid of debt and equity financing and is usually issued when owners do not want to lock into an equity value in the early phases of the company. Rather than locking into a theoretical value, issuing convertible debt raises the capital needed to get the business off the ground and in essence pushes off or postpones the valuation of the company until the next investment event takes place down the road.”
7. Pay Close Attention to Terms
Any complex financial contract is riddled with fine print, and convertible debt is no exception. Founders and investors alike should pay close attention to the terms and ensure that they understand what options both parties have when converting the debt, enforcing rules, and settling disputes.
“It is important to stress here that there are myriad types of convertible notes out there, which means that entrepreneurs should both be engaged in the negotiations of these notes, and also read carefully the fine print of the final legal documents for these complex convertible debt instruments. Otherwise, bad surprises will occur, often at critical junctions of the company’s early life, which will not help.”
8. Connect With an Investor’s Portfolio of Founders
Investors spend an extended period vetting the companies they invest in and founders should do the same. Committing to a long-term convertible debt contract with a difficult-to-work-with investor can create complications, especially if investors and founders have a different vision of the company. By exploring the portfolio of past investments, founders can get a sense for their involvement and the role that a particular investor plays in portfolio companies.
“Don’t take money from investors without talking to a few of their portfolio companies that have failed and succeeded. You should know if your investors will support you in bad times and help you with connections in good times. It’s a two-way vetting process.”
—Dipesh Desai, CEO & Founder of BillTrim
Entrepreneurs know that each fundraising situation is different. However, relying on the wisdom and experience of founders and financial professionals can help startups avoid costly mistakes at the critical early stages of the company. It’s always recommended that entrepreneurs hire a professional to help them navigate fundraising or at least enlist a mentor that can help with the process.
Pros & Cons of Convertible Debt
Businesses and investors can benefit from convertible debt. Founders can delay equity dilution while minimizing their ongoing overhead costs by leveraging convertible debt. However, it is an expensive source of funds, and while founders can tap into investor expertise, the process of getting funding may take too long.
Pros of Convertible Debt
Benefits of using convertible debt include:
- Delayed equity dilution: Early-stage startups often rely on quick decisions made by the founding team without outside influence to survive. By using convertible debt founders can maintain control while a company develops, to ensure higher chances of success.
- Minimal ongoing costs: One of the most promising features of convertible debt is the lack of ongoing payments that borrowers associate with traditional financing options. This helps startups reinvest earnings and extend their runway.
- Highly-flexible terms: The repayment terms and contract structure can help investors and companies find a happy medium that both compensates investors for their risk and grants startup founders freedom from equity dilution.
- Investor expertise: Experienced investors that put money into a startup, often bring additional expertise and value to the business. These investors can make introductions and build customer and partnership relationships.
“Early angels who decide to invest are investing in the founding team more than the product. Find an investor who believes in you and your mission. This investor will likely have relevant experience in your industry or selling to the same types of customers that you have. If the investor can bring some industry knowledge in addition to their money, you have hit the investor lottery.”
Cons of Convertible Debt
Drawbacks of using convertible debt include:
- High overall costs: Sometimes, startups may be better off with traditional financing because the cost of equity can be too high. This is true in cases of low valuation caps and subsequent fundraising rounds that can reduce a founder’s percentage ownership in the company.
- Potentially drawn-out contracts: Because most convertible notes don’t have a set maturity date and are based on future fundraising events, these contracts can extend for long periods, which can strain founder and investor relationships.
- Extensive legal requirements: Aside from a few options that are open source on the web, most startups and investors will need to work with legal counsel to structure the convertible debt agreement.
Alternatives to Convertible Debt
Both new and existing businesses have several options for raising funds without convertible debt. Most similar to it are SAFE and KISS agreements both with our simplified versions of the instrument designed for quick funding on simple terms. Founders can also raise money by borrowing from both traditional and alternative lenders.
Alternatives to fundraising using convertible debt include:
Convertible Debt vs SAFE
A SAFE or Simple Agreement for Future Equity is a simplified version of convertible debt that startups use for funding before getting a valuation. Although the SAFE may sometimes have a discount or valuation cap it usually doesn’t include an interest rate. A SAFE and a convertible note are similar, but a SAFE offers startups an opportunity to raise money more quickly and without extensive legal costs.
“The complexity of convertible notes led Y Combinator, one of the leading business incubators in Silicon Valley, to create the “Simple Agreement for Future Equity,” or SAFE note. The SAFE note is a simple instrument, which grants its holder the right to buy equity in the company at a future date. Some SAFE notes have no cap and no discount; a cap and no discount; both a cap and a discount; and no cap and no discount, but often include a “most favored nation” clause, giving noteholders some benefits at conversion time.”
Convertible Debt vs KISS
KISS is also a simplified version of convertible debt but it puts a different spin on valuation caps and discounts. Instead, investors and followers agree on an interest rate and the maturity date reducing the risk associated with any event. Founders that start businesses in predictable industries can benefit from using a KISS because they can more easily estimate its cost.
“On balance, most KISS notes are in-between typical convertible notes with defined maturity dates, caps, discounts, etc. and the SAFE instruments defined above, both in terms of conversion characteristics and simplicity (or complexity) of terms for the founders and investors. Like SAFE, KISS was developed by a leading startup accelerator, 500Startups. KISS notes come under a variety of models: Some are debt instruments, with both an interest rate and a maturity date; others are more equity-oriented, without interest or a maturity date.”
Convertible Debt vs Equity Financing
Startups considering convertible debt for funding usually do so with the pretense of raising equity financing. In comparing equity vs debt financing, founders will find that the level of involvement and potential benefits of expertise with equity financing is higher. However, investors have to come up with a company value, which can be difficult at the early stages.
Convertible Debt vs Traditional Bank Loans
Traditional loans may be a viable alternative for businesses that generate sufficient revenue to make monthly payments and helps founders wanting to avoid equity dilution. Unlike convertible debt, it will require regular monthly payments on a set term and may carry extensive qualification requirements.
Convertible Debt Frequently Asked Questions (FAQs)
We evaluated the parameters of convertible debt for startups and businesses. Individual financing agreements, especially these, will vary depending on the industry, stage of the company, and the investors providing funding. We’ve answered some of the most frequently asked questions and invite you to post your questions in the Fit Small Business Forum.
Is convertible debt considered debt or equity?
Convertible debt is considered debt until an investor has declined the option of conversion into equity. However, founders and future investors can forecast its potential impact on equity to better understand the dilution and loss of control that conversion can have.
What happens to a convertible note if a startup fails?
When a startup fails, some convertible notes will give investors the right to receive partial payment from the proceeds of liquidation. However, the most common convertible notes do not entitle the investor to any payments in the event of default. This is a particularly important point to discuss when agreeing on funding terms.
When does it make sense to raise convertible debt instead of equity?
It makes sense for a company to raise debt instead of equity if the debt is affordable and can provide sufficient capital. It’s common for smaller funding amounts, well-established companies, and product categories with a large margin. In the long run, equity costs more than debt, but many times it is the only option.
Convertible debt is a financing option for existing companies, growing businesses, and startups. Although specific terms and costs can vary by contract, it typically protects investors from downside risk and founders from early-stage equity dilution. There are multiple convertible debt startup funding options that both investors and businesses can consider.