Convertible Debt Startup: A Comprehensive Guide

Convertible debt can be a game-changer for startups looking to raise funds without giving up equity.

It's essentially a loan that can be converted into equity at a later stage, often when the startup reaches a certain valuation milestone. This allows investors to participate in the startup's growth without having to worry about the risks associated with early-stage investments.

Startups can issue convertible debt to investors in exchange for a loan, which can be used to fuel growth or pay off existing debts. The loan amount can vary, but it's typically a smaller amount compared to a traditional equity investment.

Convertible debt can be structured in various ways, including interest-bearing notes and zero-coupon notes, each with its own set of terms and conditions.

Convertible debt is an investment option used by early-stage investors to provide funds to a startup while delaying the valuation of the startup until a later date. It's essentially a loan that converts into an equity investment at some future date.

This type of funding is often used as a seed investment, coming before the startup's first round of stock offering, also known as the series A funding round. The investor gives the startup money to build the business, but unlike bank loans and credit cards, the loan isn't paid back with more money.

Instead, when the time comes, the original amount of the loan is converted into equity, or stock, in the new company. This unique feature of convertible debt makes it extremely desirable to early investors, who are compensated for taking on risk by leveraging two essential components: a discount and a cap.

Convertible debt is a mash-up of debt financing and equity financing, where you borrow money from investors with the understanding that the note will either be repaid or turned into a share in the company at some later point in time. This conversion happens after an additional round of fundraising or once the business reaches a certain valuation or share price.

The goal of convertible debt is for note holders to invest capital into an early-stage startup company now without having to worry about what the exact valuation might be just yet. The convertible note structure essentially "punts" the valuation until a later funding round, which is typically when venture capital funding steps in.

Convertible debt notes have two key characteristics that distinguish them from ordinary loans: the discount and the valuation cap. These features change the DNA of a convertible debt note dramatically as a loan species.

The discount rewards early investors for taking larger risks than later investors by offering them the right to obtain shares at a cheaper price than that paid by Series A investors. This can result in a higher rate of return for early investors.

Similar to ordinary notes, convertible debt notes contain an issuance date, interest rate, and maturity date. Unlike conventional loans, repayment is with equity. The valuation cap and discount incentivize investors, but often bewilder founders.

Convertible debt terms usually provide that the early investor has the option to choose between the lower of either the discount or cap conversion after qualifying financing is received at the Series A round.

Convertible notes are a type of short-term debt that will convert into equity based on the next qualified financing round.

The terms of convertible notes are fairly standard, and most discussions around setting up a convertible debt instrument will involve these key terms.

Convertible notes are intended to be a short-term solution for startups, providing a loan that will eventually convert into equity.

The cap in convertible debt applies to the share price, which is an essential component of these instruments.

Convertible notes are often used in early stages, and the interest accrued on these loans will be added to the equity when they convert.

A convertible debt note's DNA is dramatically changed by two key characteristics: the discount and the valuation cap.

These features reward early investors for taking larger risks than later investors by offering them the right to obtain shares at a cheaper price.

The discount gives early investors the right to obtain shares at a cheaper price than that paid by Series A investors.

The valuation cap sets the maximum value of a company when Series A closes, giving an advantage to earlier investors.

Similar to ordinary notes, convertible debt notes contain an issuance date, interest rate, and maturity date.

Repayment is with equity, which is a departure from conventional loans.

The discount and cap are features that offer early investors two different ways to value their original investment when the Series A round closes.

The conversion price is the lower of the two methods that results in more shares issued to the early investor upon conversion.

A 20% discount can give an investor a 1.25x return on their investment, calculated by dividing the value of the number of shares received by the original investment.

The equation is simple: investment amount divided by discounted price. For instance, if the investment amount is $500,000 and the discounted price is $0.80 per share, the investor gets 625,000 shares.

Without a cap, the investor would've only received 625,000 shares applying the 20% discount. But with a cap, they can receive more shares, resulting in a higher return.

A 20% discount rate means that if the company gets a $1,000,000 valuation in the future, the investor's money converts at a $800,000 valuation, making their $100k investment worth more.

Using the pre-money method, where the company's valuation is fixed, the note's conversion price is based on that fixed valuation. This means that the investor gets a certain number of shares based on the fixed valuation.

For example, if the company's valuation is fixed at $1,000,000 and the note's conversion price is $0.80 per share, the investor gets more shares than if the valuation was higher.

Convertible debt financing is a great way for startups to raise funds without worrying about the valuation of their company. This type of 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.

The main appeal of convertible debt for early- and seed-stage companies is that it delays the debate over a company's value. This is especially helpful for startups that are still in their early stages and don't have a lot of data to back up a strong valuation.

Here's how it typically works:

The trigger event is usually the next round of funding, where the value of the company is better known. This allows founders and investors to punt on the valuation question until the company is more robust and has more data to support a strong valuation.

Issuing convertible notes can be a fast and simple process, often taking only a day or two.

Convertible debt's legal fees are significantly lower than those associated with issuing preferred stock, ranging from $1,500 to $2,000.

One of the key benefits of convertible debt is that it rarely gives investors control rights, allowing startups to maintain control over their business.

Here are some of the key advantages of convertible debt:

From the investor's perspective, convertible debt can be a complex and sometimes contentious issue.

VCs generally prefer to invest in preferred stock over convertible debt, as it gives them more control and less risk. However, there are some incentives that might make them agree to 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.

Investors may not like the terms of convertible debt, and if you're not careful, you might turn off prospective investors who would otherwise consider investing.

In some cases, investors will agree to convertible notes simply because they're the easiest way to get a deal done.

Convertible debt terminology can be complex, but it's driven by a few key terms that govern the events that trigger the debt to convert and the value of the existing investor's capital when their debt converts to equity.

The discount is a feature that rewards early investors for taking larger risks than later investors by offering them the right to obtain shares at a cheaper price than that paid by Series A investors.

A valuation cap is another key characteristic that rewards early investors for their disproportionate risk by setting the maximum value of a company when Series A closes.

Ordinary convertible debt notes contain an issuance date, interest rate, and maturity date, but repayment is with equity, not cash.

The discount and cap are features that offer early investors two different ways to value their original investment when the Series A round closes with a concrete valuation.

Early investors have the option to choose between the lower of the discount or cap conversion, which results in more shares issued to the early investor upon conversion.

Most convertible debt documents include standard terms such as the valuation cap, discount, interest rate, maturity date, and issuance date.

Raising money as a startup can be a daunting task, especially when it comes to valuations. Most early-stage companies are almost impossible to value by seed investors in their infancy, making it hard to determine a pre-money valuation.

The goal is to let a later investor determine the value of the company after it has matured enough to do so. This can be a risk for both the startup and the investor, as the future valuation could favor either party.

Convertible debt deals are typically intended to convert to equity at a future date, but that conversion is almost always intended for a future financing round. There's no guarantee that early-stage startups will raise more money, either because it can't or it doesn't need to.

A valuation cap can protect against this risk by limiting how high the future valuation can affect the existing convertible debt investment. This can incentivize early investors and provide a safeguard for them.

If the startup doesn't raise more money, the convertible note will simply turn into a traditional loan, and the startup will have to pay it back unless they can agree on a fair valuation to convert the note to equity. This provides both parties with optionality to consider either outcome.

A future valuation could be lower than anticipated, especially if the startup faces challenges such as delayed product shipping, low customer payments, or a longer time to profit. By locking in a valuation now, startups can avoid potential downside risk if the valuation they're getting now feels reasonable.

Convertible debt may not be the most appealing option for investors, as it gives them less control and is riskier than issuing preferred stock. This is because convertible debt often features a discount that rewards early investors for shouldering more risk.

Investors may not like the terms of convertible debt, preferring to negotiate a valuation now to avoid potential discounts later. However, convertible notes can be a convenient way to get a deal done, especially in early-stage companies where valuations are hard to determine.

Some investors will agree to convertible notes due to FOMO (fear of missing out) or to get into a deal quickly, eliminating the need to debate valuations. However, this can be a drawback for startups, as it may turn off prospective investors who prefer to negotiate a valuation upfront.

Here are some key challenges and considerations to keep in mind:

In some cases, convertible debt can be beneficial for startups, especially those that are not yet ready to set a valuation for their company. This is because convertible notes tend to favor the startup company, providing a mechanism where the entrepreneur can give up less future equity.

Convertible debt isn't without its challenges. Investors may not like the uncertainty of convertible debt, preferring to negotiate a valuation upfront.

The lack of a debt component in SAFE investments means there's no interest rate or maturity date, which can put more risk on investors.

Convertible debt often features a discount that rewards early investors for shouldering more risk, but this can be a sticking point for some investors.

Investors may be turned off by the terms of convertible debt, so it's essential to have an open dialogue about preferences.

Here are some potential challenges to consider:

Raising more money isn't always a guarantee, and convertible debt deals are typically intended to convert to equity at a future date, but not always.

If an early-stage startup doesn't raise more money, the convertible note will simply turn into a traditional loan. This is because there's no guarantee that the startup will raise more money, and some startups may not need to.

Convertible notes can be a hedge between taking on equity versus some other debt investment, giving both parties optionality to consider either outcome.

If a startup is on the fence about future funding, using a convertible note can be a way to delay the decision, but it's essential to understand the terms and conditions of the deal.

Here are some key considerations to keep in mind:

It's crucial to understand that convertible notes are not a guarantee of future funding, and startups should carefully consider their options before deciding on a financing strategy.

A SAFE investment can be a bit tricky, and one of the potential downsides is that it's not a traditional investment. A SAFE treats the capital invested not as equity in the company or as debt. It's more like an "IOU" that sits in stasis until a future equity event happens.

This means that if no conversion event happens, investors may not end up with any common stock at all. It's actually possible for investors holding convertible notes (as a SAFE) to wind up with no common stock.