2. 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 borrower's company.
3. WHEN DOES CONVERTIBLE DEBT CONVERT TO
EQUITY?
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).
4. 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.)
5. What are its advantages?
Easy For Startup Businesses to Acquire
If you're 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.
6. 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.
7. 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 company's assets are divided. As the note is secured against the
borrower's assets, an investor may feel more secure lending using
convertible debt than he would through a traditional bank loan.
8. 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 company's assets, and the lender has the right to
liquidate the assets to get his money. This can put a company
in dire financial straits.
