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Convertible Debt: What It Is and How It Works

Founders often have questions about how to use convertible debt as part of their funding strategy. Many want to avoid a valuation discussion, so the idea of delaying this negotiation by using convertible debt sounds appealing. But convertible debt involves tradeoffs, so it’s important to make sure you understand the basics before you go down that path.

What is convertible debt, and why is it popular for funding?

Convertible debt is basically a loan that you and your investors agree will convert into equity at a specific date, usually after your next round of funding. The principal appeal of convertible debt for early- and seed-stage companies is that it delays the debate over a company’s value. After all, if a startup is two guys in a garage with a good idea, how much is that company worth? Founders and investors will have wildly different concepts of value.

Issuing convertible notes lets the company punt on the valuation question until the Series A, when hopefully the company is a lot more robust and has a lot more data to back up a strong valuation. Some other advantages include:

  1. Issuing convertible notes is fast and simple, often taking only a day or two.

  2. Convertible debt’s legal fees are cheap, clocking in at $1,500 to $2,000 as opposed to the several tens of thousands of dollars in legal fees for issuing preferred stock.

  3. Keeping control. Convertible debt rarely gives investors control rights.

Why do VCs like convertible debt?

Generally speaking, VCs would rather snap up your preferred stock than issue convertible debt. Convertible debt is riskier and gives them less control. But there are some incentives for VCs to sign off on convertible debt.

Convertible debt often features a discount that rewards early investors for shouldering more risk than later investors. This discount gives them the right to buy shares at a cheaper price than Series A investors. In addition, if your business fails and your assets are liquidated, debt gets paid off before equity, so your convertible debt providers have slightly more protection than your equity investors. That said, early-stage startups often don’t have much in the way of liquidation value.

Should you or shouldn’t you?

It’s not always a good idea to use convertible debt in the early stages. Sometimes, agreeing on an initial valuation and then increasing it in each subsequent round of funding can be a better financial approach. It all depends on how quickly you want your company to move in terms of raising venture capital. Many investors also want to know exactly how much of your company they’ve acquired, so taking on equity risk while getting convertible debt is not an attractive proposition for them. Funding with convertible debt can be a good strategy, but make sure that it benefits you and that you are fairly compensating your early investors.

This is only the tip of the iceberg when it comes to convertible debt, but hopefully you now understand the basics well enough to determine if it’s a good funding option for your business.

Are you using convertible debt? Drop us a comment below and tell us why or why not.