A Mini-Primer: Understanding Convertible Debt

When your startup needs to raise cash, the conversation about convertible debt generally begins.  in effect, the investor would be loaning money to a startup and instead of a return in the form of principal plus interest, the investor has the option to convert their return into equity in the company.

How do I think about convertible debt?

When a company borrows money from an investor or a group of investors and the intention of both the investors and the company is to convert the debt to equity at some later date. Typically the way the debt will be converted into equity is specified at the time the loan is made.

When evaluating a convertible note, there are a few key parameters that must be kept in mind:

Discount Rate

Investors will often have a valuation discount relative to investors in the subsequent financing round, which compensates the initial investor for the additional risk born by investing earlier.

Valuation Cap

The valuation cap is a plus for bearing risk earlier on. It effectively caps the price at which the notes will convert into equity. Note often have upside, if the company grows early and well.

Interest Rate

Interest often is accrued in a convertible note.  Interest accrues to the principal invested, increasing the number of shares issued upon conversion.

Convertible notes are often issued so that both investors and startups can avoid a valuation that can really come later during Series A financing, after the idea of the company has become more solidified and moved forward with planning and potentially first sales.

There is security for both the investor and the startup in this plan.  Ideally, an investor wants to convert the bond to stock when the gain from the stock sale exceeds the face value of the bond plus the total amount of leftover interest payments.