Startup Lawyer | The Basics of Convertible Debt Financing
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The Basics of Convertible Debt Financing

Posted 23 Dec 2008

Selecting the optimal structure when raising capital for your startup can be a challenging task. When clients ask me for my recommendation, I find myself recommending the convertible debt financing route more often than traditional equity financing (i.e., I’ll give you $100k for 20% of your company’s stock).

So what is convertible debt?

Convertible debt financing is basically an investor loan to your startup that has a future conversion-to-equity feature. That is, your startup’s investor gives your startup a loan like a bank would, but the outstanding balance of this loan will convert to shares in your corporation at a future date.

When does convertible debt convert to equity?

Convertible debt typically converts to equity the next time your startup raises capital (think venture capital or similar large investor). Technically, this large raise is called a “qualified financing” per the convertible debt agreements (note and note purchase agreement).

How does convertible debt convert to equity?

Convertible debt converts to equity based on the valuation your startup receives from the venture capital firm in the “qualified financing.” For example, if your venture capital investor ends up paying $1 per share for your startup’s preferred stock and you have $800,000 of convertible debt, the investor will receive 800,000 shares of preferred stock. The loan will then be cancelled. (Note: Convertible debt often converts to preferred stock at a discount than what the venture capital investor pays for the preferred shares.)

So why do I recommend convertible debt so much?

Simple: It delays the valuation discussion. I see many founders struggle with their investors over a valuation to do a straight up cash-for-shares equity investment. And this struggle can last for months and eat up development time.

5 Comments
  • Convertible Debt Financing | KillerBlog
    Posted at 11:11h, 23 December Reply

    [...] that? It’s good to brush up on financial jargon every once in a while (specially when it’s the slowest news day I can think of). Tips Towards [...]

  • Roseanderson26
    Posted at 07:29h, 16 November Reply

    Hi,
    As I see in your site there is lots of good information available on convertible debt and related information on investment.Interest Convertible debt is actually deduct from the profit before tax which is beneficial from issuer point of view.The investors also benefited as the convertible debt bond transfer to equity capital after stipulated time.
    I want to upload one quality article on convertible debt for your site if you agree than please contact me at roseanderson26@gmail.com

  • Roseanderson26
    Posted at 07:29h, 16 November Reply

    Hi,
    As I see in your site there is lots of good information available on convertible debt and related information on investment.Interest Convertible debt is actually deduct from the profit before tax which is beneficial from issuer point of view.The investors also benefited as the convertible debt bond transfer to equity capital after stipulated time.
    I want to upload one quality article on convertible debt for your site if you agree than please contact me at roseanderson26@gmail.com

  • PK
    Posted at 09:57h, 17 September Reply

    Hi, Thanks for the great info on the site, What happens when a startup decides not to go for a Series A or exit, does the note become payable back to the investor or would it convert to common stock at a pre-determined valuation.

  • Dan Lammot
    Posted at 23:56h, 20 December Reply

    Q: should amount of convertible note already invested be deducted from company value to determine equity value pre-series A close?

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