Getting financing for your tech startup during the early, pre-revenue stages is always a challenge. That’s why, for the past decade or more, many entrepreneurs have been turning to convertible debt rounds with angel investors to get by until they gain revenue and traction.
What is convertible debt?
Convertible debt is like a loan, but with two important differences. First, unlike a traditional loan, you don’t need to make payments right away. Instead, you make a lump sum payment of principle and interest at some point in the future—typically after your next funding round. Second, instead of paying the loan back, the debt can be “converted” to equity shares for the investors at a significant discount.
Why other options might not work… yet
Many new entrepreneurs wonder why convertible debt has become so popular for early-stage companies when it seems like there are other viable options out there. Part of the reason for its popularity might be other funding mechanisms’ scarcity.
Series A round with a VC
Unless you have a successful track record as an entrepreneur, it’s almost impossible to interest venture capital investors in a Series A round at this stage. Over the years, the average Series A round has moved later and later in the company’s development. Now it’s rare to raise a Series A without some revenue or other validated traction.
Revenue-based financing can be a great way to fund growth—as long as you have revenue. Since revenue-based investors take a percentage of topline revenue as a loan payment, they’re unable to fund pre-revenue companies. Most will want you to hit a revenue benchmark before they fund you. At Lighter Capital, for example, we require at least $15K/month in revenue before we will consider offering financing.
Banks are reluctant to fund small, new companies without significant hard assets or annual revenues in excess of $5 million. This makes it virtually impossible for a pre-revenue tech startup to secure a traditional loan—unless one or more of the co-founders are willing to personally guarantee the loan with hard assets, such as homes, retirement funds, and life savings. And if you’re willing to bet your personal assets on your business, you might as well invest that capital directly in the business instead of paying interest to and dealing with a bank.
Why early-stage convertible debt has become so popular
Convertible debt is attractive to early-stage companies for a few reasons:
A fairly-structured convertible debt offering is the sort of investment opportunity that will pique the interest of angel investors. For early investors, convertible debt offers a chance to get in on your first equity offering (to be offered at some point in the future) at a significant discount (usually 20–30%) in exchange for giving you money now.
A convertible debt offering allows the entrepreneur to offer unpriced equity at a time when their company would otherwise be valued quite low. By putting off the issue of startup valuation until the debt comes due, the entrepreneur can build up the business—and its valuation—so that there’s less dilution when Series A equity is issued.
Because determining the valuation of a pre-revenue company can be so complicated, many angel investors are also happy to avoid arguing about it. They also appreciate the downside protection of simply getting their principle back with some modest interest if the business doesn’t take off enough to meet the necessary milestones for conversion.
Convertible debt can be a great way to structure angel rounds, but there are a few traps buried in typical convertible debt terms. Make sure you check for multiple liquidation preference, which can mess up your cap table and make your company unattractive for later investors, and full ratchet anti-dilution rights, which reprices the investors shares in the case of a down round (thus severely diluting the owner’s equity).