A User-Friendly Guide on Convertible Debt
Learn everything you need to know about convertible debt in startups.
As companies scale and grow, they may take on different commitments, challenges, and goals and explore a variety of different paths when it comes to the financial decisions made for growth at the company. There are a number of different ways a company can be set up, a variety of ways it can get off the ground with finances, and many different possible outcomes for a company’s future.
How you choose to finance your company, especially early on, can determine a lot about the course your company will take. One option to explore early in a startup’s journey, primarily pre-Series A fundraising round, is convertible debt. Here at Visible, we’ve put together a user-friendly guide on Convertible Debt.
What is Convertible Debt?
So, what exactly is Convertible Debt? Simply put, Convertible Debt is a loan or a debt option from an investor that is paid with equity or stock in a company. The big difference between a convertible debt investment and a traditional investment is that a traditional investment is typically for an exchange of equity or stock immediately at a known valuation. A Convertible Debt is a loan or debt option that is paid with equity or stock in a company at a future date. This future date maybe when a firmer valuation is determined by the raise of a larger round or big growth in revenue. Typically convertible debts are paid with converted equity in a year or two max.
Related Resource: What Are Convertible Notes and Why Are They Used?
Convertible Debt vs. Convertible Bond
Similar to convertible debt, a convertible bond is a fixed-income loan or debt option that can be converted into a predetermined amount of common stock or equity. There are two main differences between convertible debt and a convertible bond. First, a convertible bond’s conversion timeline is usually at the discretion of the bondholder, while convertible debt’s timeline to conversion is typically monitored and determined by the lender. Next, a convertible bond yields interest payments that can also be converted into equity or stock as well. Convertible debt is pure capital and does not have interest payments associated with it.
How Does Convertible Debt Work?
Many startups are not able to pull the detailed financial information a big creditor, bank, or lender would typically want to see to offer money to a business. Convertible debts are a great option for startups due to this reason. Convertible debt allows businesses to get the early capital needed based on the future success of the company. Investors who agree to convertible debt agreements want their investments to make money, so they’re more likely to do what it takes to help the company succeed. Because the more a company succeeds, the more money those investors will make.
Like any traditional investment, convertible debt happens in rounds or cycles of money being loaned or cashed out and returning in the form of equity or cashing in. At the start of a round, the terms of the convertible debt are set. For example, sometimes a warrant or discount are terms of a convertible loan, or sometimes there’s a limit on the value of the debt when it is converted. In some cases, convertible debt can be structured with discount terms, typically no more than 25%. This means that when the loan ends at the end of the round the investor can purchase stock at an agreed-upon discount.
Benefits of Convertible Debt
There are a number of different benefits of choosing to take on convertible debt in your startup. Convertible Debt can be a powerful funding mechanism. Here are the top benefits to consider with convertible debt:
1. Convertible Debt is a Simple Financing Option
With the terms set in place as part of the convertible debt agreement, it’s a very straight-forward option. X investor loans Y company $100,000 in exchange for $200,000 worth of shares within two years. The founder or startup team, they have 100k in the bank and the support of a connected investor with a vested stake to ensure that 100k converts to the best possible valuation for their future shares as possible. It’s a pretty straightforward transaction, and even if there is a discount or rate increase baked into the debt, it’s set ahead of time and there are no changes over the life of that debt.
Related Resource: 409a Valuation: Everything a Founder Needs to Know
2. Convertible Debt is a Low Risk and Efficient Method
Convertible Debt is low risk and there is no interest associated with said debt. It also does not require traditional background elements like credit history or existing money in the bank to work. Therefore it also won’t affect any existing credentials like credit score if the debt investment doesn’t quite pan out. By taking on convertible debt upfront, startups can save existing capital and build out a longer runway for themselves making the method of taking on outside investment via convertible debt extremely efficient.
3. Investors with Convertible Recieve Voting Power
Typically, investors taking the route of putting up money in a convertible debt deal receive voting power. This is because they can set the equity amount they want and since convertible debt is more common for new, pre-Series A companies, these investors choosing to invest this way can invest an amount that will get them a large enough return percentage for a board seat. This is something that is harder to do at later funding rounds when it’s traditional capital for equity exchange. Investors see the opportunity to get voting power and influence a company as a great benefit to their investment as they can have a bigger say in where their investment goes. This can also be helpful to a founder raising capital – with the incentive of early voting power on the board up for grabs, larger seed rounds may be able to be raised on convertible debt.
Related Resource: How to Write a Business Plan For Your Startup
4. Convertible Debt Provides Fixed Income for Noteholders
For Noteholders, Convertible Debt is a great option because it provides direct, fixed income over a shorter amount of time for said investment – the guarantee that the investment will convert to equity within a period of time is more predictable and that equity will then grow once it converts and the company continues to grow.
Drawbacks of Convertible Debt
While Convertible Debt has many benefits, it does come with some drawbacks as well. Be sure to consider all the drawbacks of convertible debt such as:
1. Failure of Repayment
If for some reason the convertible debt can’t be repaid with the equity or stock promised, often the lender has the right to demand repayment via other means which could lead to the loss of other items or controls in the business, causing a business to even liquidate its assets for repayment in some cases.
2. The Risk of Bankruptcy
Plain and simple, failure of repayment can lead to the liquidation of a company’s assets which can lead to bankruptcy. This is a major risk if convertible debt goes wrong.
3. Stringent Indenture Provisions
A strict set of rules, agreements, and details – or stringent indenture provisions – are to be expected when taking on convertible debt. This can be a major drawback depending on how long-term said provisions are. Depending on the growth of your company you may be bound to your lender in a way that has negative consequences for the founder/owners or the business as a whole but has great benefit to the investor. Consider all provisions and contingencies and review them thoroughly when taking on convertible debt.
4. Losing Control in the Company
While a benefit of a lender with convertible debt is a voting board seat or voting power within the organization for certain decisions, this can lead to a major risk for the company. If the controlling stake is removed from the founders, or the vested interests of the voting members changed, the original founding team may no longer have a say in their company and the vision and early mission may evolve without their knowledge. In some cases, this could also lead to the removal of original leadership from the company that raised the convertible debt round in the first place.
Why do Startups use Convertible Debt?
At the end of the day, despite the drawbacks, the pros of quick, efficient, and straightforward financing in the form of convertible debt are why startups choose to use it. Any opportunity to secure large investments quickly without a detailed credit history and the benefits of bringing on seasoned investors to help a business at its earliest stages are great bets to take into the risk and reward consideration, with the reward justifying the risks of taking on this debt.
Related Resource: Valuing Startups: 10 Popular Methods
Convertible Debt Example
One great real-life example of a company using Convertible Debt is Ledgy. The equity management software company from Zurich talks through their own company’s experience of using convertible debt to grow their business. Read more about it here.