Getting financing for your tech startup during the early, pre-revenue stage 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.
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.
How Does Convertible Debt Work?
Convertible debt, or convertible debt financing, is like a loan, but with two important differences:
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.
Instead of paying the loan back, the debt can be “converted” to equity shares for the investors at a significant discount at a specific date, usually after your next round of funding.
The main 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 perceptions of value.
Issuing convertible notes in exchange for funding lets your startup punt on the valuation question until your Series A round, when hopefully the company is a lot more robust and has a lot more data to back up a strong valuation.
Convertible debt advantages also include:
Issuing convertible notes is fast and simple, often taking only a day or two
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
Keeping control — convertible debt rarely gives investors control rights
Why is convertible debt attractive to young startups?
Let's get into the nitty gritty of why you might want to defer a valuation of your company when it's in its infancy and pursue convertible debt financing:
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.
Why do startup investors 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 to sign off on convertible debt for VCs and other early investors.
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.
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.
Convertible Debt vs. Other Funding Options
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 the difficulty to secure funding from other sources at this pre-revenue stage.
Series A round with venture capital
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
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.
Bank loan
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 bank 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.
Is Convertible Debt Good for Startups?
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 a less 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.
Terms and conditions to watch out for
Convertible debt can be a great way to structure angel rounds, but there are a few traps that may be buried in convertible debt terms. Here's what you need to look out for in the fine print:
Keep a close eye on liquidation preferences, which can mess up your cap table and make your company unattractive for later investors
Understand valuation caps, which protect investor’s upside risk by setting a floor on their purchase price
Also look for full ratchet anti-dilution rights, which reprices the investors shares in the case of a down round (thus severely diluting the owner’s equity)
This is only the tip of the iceberg when it comes to convertible debt, but hopefully you now have enough of the basics to weigh the pros and cons for your startup.
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