Convertible Debt Basics

In our work with startup founders, we’ve come to discover that convertible debt is a confusing subject for many. It’s a complicated and nuanced topic, but here are the three things you need to know up front:

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Trust us, there is far more to convertible debt than knowing these three things, and we’ll cover them in subsequent posts, but let’s first arm you with the basics.

Delay Your Valuation

For many founders, the most meaningful characteristic of convertible debt is around valuation; specifically, the fact that you don’t need one.

If you are trying to raise $50,000 in seed stage capital, chances are you don’t have a lot of traction, and that can make valuation painful. Imagine that the investor values your idea in its current state at $100,000 – meaning you’d be parting ways with 50% of your company for a grand prize of $50,000. The likelihood is that you’d not do that deal; it’s just too painful to part with that much of your company for that little cash.

So what’s a startup to do? Well, convertible debt was created with this very scenario in mind, where a valuation is incredibly hard to determine or, like in the example above, just too hard to stomach. By deferring valuation until a follow-on capital event, you avoid the complexity and pain of doing so at the formative stages. You’re essentially agreeing to wait and let your startup grow up a bit before putting a price tag on it.

Give Investors Upside

With convertible debt, you give investors upside in three ways:

 

1. A Valuation Cap
   You limit the highest valuation the investor would pay, essentially giving them a guaranteed minimum percentage of the company in the event that things go really well.
2. A Discount: Let’s say your note includes a 20% discount. When the note converts, the investor will get their initial contribution plus an additional 20%.
3. Interest Rate: The note will accumulate interest from the date it is signed until conversion, at which point the interest will be rolled in with the initial contribution.

Convertible Debt is Quick

Because it only requires a few short and sweet documents it is both fast to create them, and easier to negotiate them.

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What Now?
If you need to raise funds, and think valuation is currently too difficult or too painful, convertible debt is a good way to do it quickly, while also giving your investors upside. Need more help making this decision? Check out the next installment of this series, written to help you decide if convertible debt is right for you. And of course, give us a shout @startupsco to continue the conversation!