Everything You Need To Know About Convertible Debt For Startups

Startups face multiple options when looking for capital. One of the first questions founders actually often ask us is whether they should raise debt or equity. Well, there is a third option: convertible debt (or “convertible notes”).

Convertible debt is a hybrid financial instrument that shares multiple advantages of debt and equity. That’s why convertible notes have become so popular over the past 10 years. Yet, there are a few things you need to know before even considering it.

In this article we will cover what convertible debt is, how it works, its pros and cons and key terms. Most importantly, we will tell you whether you should use it or not for your startup. Let’s dive in.

What is convertible debt?

A convertible debt is a type of short term debt that converts into equity. Convertible notes are typically used by early stage equity investors for a number of reasons which we are discussing below.

Unlike traditional debt, convertible debt is a financial instrument whereby the investor lends money to a startup in exchange for shares of the company at a later stage instead of repayment of the debt plus interest.

How does it work?

Before the investor actually lends money to a startup, a short-form agreement is signed between the 2 parties in which the key terms are settled (see below).

Convertible debt is very attractive also for the startups themselves as, unlike equity, it doesn’t require a lot of documentation. The term sheet is actually really short (1/2 pages – click here for an example).

Once the term sheet is signed, as per the key terms we’ll discuss below, the investor lends money to the startup. The debt comes with a maturity date when the debt must be converted into equity, at the latest, or repaid to the investor.

Like any other form of debt, the convertible note also comes with interest: the interest accrues over time until the debt is either converted into equity, or paid back to the investor at the maturity date.

Logically, investors aren’t really interest in getting the loan repaid to them at maturity (otherwise, they would look into venture debt instead).

Instead, investors want to benefit from the equity upside. That’s also why investors usually extend the maturity date when a startup hasn’t yet converted a convertible note into equity instead of calling for an actual repayment.

Note: you might have heard of SAFEs, they are different vs. convertible notes. For more information on SAFE and whether you should use it for your startup, read our article here.

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So what happens when we convert notes into equity?

The startup grants the investor a number of shares in return for the cancellation of the convertible debt. In other words, it swaps debt into equity.

A convertible note becomes equity whenever there is a “qualifying financing”: the startup is actually going through an equity raise beyond a certain minimum amount. When raising equity from new investors, the startup will at the same time grant shares to the convertible debt investors as well.

That’s where convertible debt becomes interesting for startups. Instead of going through 2 different valuations, which could raise potential issues and take significant effort, the startup sets the valuation of shares of the convertible note holders at a discount of the valuation of the new equity investors. That way, we kill two birds with one stone: one valuation only for 2 different rounds.

Without saying, it’s also very interesting for convertible notes investors who get the same shares at a discount. Indeed, they invested earlier and therefore took more risks vs. the new investors.

Convertible notes: pros and cons

Pros

  • Fast access to funds. Unlike straight equity, convertible debt can be obtained very quickly. The documentation is very light (as it is supported by the term sheet of the future equity round)
  • Delays valuation. Raising convertible debt instead of equity allows the company to delay valuation. Indeed, any equity fundraising requires a company and new investors to agree on a valuation. That way, we know how many shares each new investor should get for their investment. Instead, convertible notes are debt: the company delays the issuance of shares until a future fundraising round
  • No repayment. Unlike venture debt, convertible debt doesn’t need to be repaid if everything goes well. Instead, the startup issue shares in return for cancelling the debt

Cons

  • Dilution. Startups swap convertible notes into equity at some point in the future. This mean you will have to give away shares in your business to convertible debt investors. If you aren’t sure whether you should give away ownership in your business, convertible debt might not be for you
  • Risk of not converting debt into equity. If the startup fails to raise sufficient equity (“qualifying financing”) in the future, it will need to repay the debt by the maturity date. The problem is that startups often don’t have sufficient cash flow to repay debt and interest. This is a very risky situation whereby calling for debt repayment might trigger a bankruptcy. To avoid such a situation, investors and startups often renegotiate the terms: they either extend the maturity date, or convert debt into equity right away

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Convertible notes: key terms

Like any other debt instrument, convertible notes have specific terms which we are explaining below. Make sure you understand them before you sign a convertible debt term sheet.

Maturity date

The date when the note is due and needs to be repaid, or converted into equity. It typically ranges from 12 to 24 months from the closing date, with 18 months being the most common.

Interest rate

The interest at which the debt accrues over time, usually 5%.

If the startup swaps the convertible note into equity at or before maturity, it does not pay interest in cash to the investor. Instead, the startup includes accruing interest when determining how many shares the convertible investor should get.

Instead, if the startup repays the debt to the investor at maturity, it logically needs to repay both the debt and the interest that accrued over time.

Discount

Convertible notes investors usually get an additional discount on the price of the shares. The discount compensate them for the risk they took by investing earlier.

For example, let’s assume:

  • A $200k convertible note with a 20% discount rate
  • The company raises money at $1 per share at the next equity funding round

Therefore, instead of getting 200,000 shares, convertible debt investors get 250,000 ($200k / $0.80 per share).

Valuation cap

The cap sets the maximum price at which the notes will convert into equity. Logically, the lower the cap, the better for the investor.

Let’s assume convertible investors invested $1 million in startup (no accruing interest for simplicity).

Later, the post-money valuation at the next funding round is $5 million. Assuming a $1 share price for simplicity, convertible debt investors get 25% equity (1,250,000 shares) at $0.80 a share.

Because the valuation is not set when convertible debt investors lend the money, a startup might want to cap the amount of equity it will have to give away in the future.

For example, if valuation is $10 million instead, the startup will only have to give away 12.5% equity instead (1,250,000 shares / 10,000,000 total shares).

This is where valuation cap is useful: it sets the minimum valuation at which the debt converts into equity to protect the startup from significant dilution. In our example, assuming a $10 million valuation cap, the startup would only have to give away a 12.5% maximum of equity.

Should you use convertible debt for your startup?

Convertible notes are ideal for high-growth early-stage startups.

Indeed, early stage startups might not have the resources nor the time to go through a straight equity round. Instead, convertible debt act as a “bridge” until they raise a bigger round in the future. No lengthy paperwork or expensive legal fees, and the money is available within the bank account under a few days only.

Also, convertible notes are all the more attractive when startup grow very quickly. For high-growth startups, later rounds usually get high valuations, allowing a startup to raise convertible debt today at very attractive terms. The equity it will need to grant convertible investors decreases as the valuation increases.

Therefore, if you are considering convertible debt for your startup, be sure to understand the risks. If you can’t demonstrate strong growth within the next 18 months or so, convertible debt might actually be dangerous. Be sure to carefully read the terms of your term sheet before you go ahead.

Whether you are opting for convertible debt or equity for your startup, investors will ask for a solid investment presentation and financial plan. SharpSheets can help you do so, check out our financial model templates.

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  • Investor-friendly
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  • CPA-developed financials
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