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How Does Convertible Debt Work?

Posted by Early Growth

March 5, 2012    |     4-minute read (672 words)

In the start-up consulting side of Early Growth Financial Services, we often have start-up founders asking about convertible debt and how it can help them when raising venture capital and angel funding. Many start-ups want to avoid having a valuation discussion with their investors, and so they’ll turn to convertible debt since it delays valuation. However, there are up-sides and down-sides to using convertible debt early in the development of a start-up, so it’s important to go over the basics before you make a decision.

Why Do Start-ups Use Convertible Debt?

First of all, what is convertible debt? It’s basically a loan, either from a VC or angel investor, that you agree to convert into equity at a specific date, usually after your next round of funding. Start-ups often turn to convertible debt because it allows them to spend less time at the negotiating table with investors, dilutes equity less since the company is issuing debt that will later be converted, and it keeps transaction costs low (i.e. legal fees). Convertible debt makes the most sense when a start-up is doing a friends and family round because it’s just easier to offer convertible notes instead of getting into a difficult discussion over equity and shares in the company so early on. With convertible debt, you can delay that debate; and if you have confidence in your company, the hope is that your equity will be worth much more later.

Why Do VCs Accept Convertible Debt?

Generally speaking, convertible debt is not terribly attractive to VCs since they’re taking more of a risk by accepting your debt instead equity, but there are advantages for them. Convertible debt generally converts at a discount when the time comes, the idea being that since they did invest early on, then the VC should get more of a perk than mere interest on a loan. Additionally, in a liquidation, debt will be paid off before equity; so investors do have some security by taking debt instead. However, that doesn’t really apply to early-stage start-ups since they often don’t have much in the way of liquidation value.

To Use Convertible Debt, or Not to Use Convertible Debt

It’s not always a good idea to use convertible debt in the early stages. Sometimes, setting the value of your equity and then increasing it in each subsequent round of funding is a better financial model, but it really depends on how quickly you want your company to move in terms of raising venture capital. Not only that, but many investors want to know exactly how much of your company they’ve bought, so taking the equity risk and getting convertible debt is not appealing for them. That doesn’t mean convertible debt is necessarily a bad idea, just that you need to be careful. It can, of course, be a good foundation if it benefits both sides equally and the compensation offered for the loan is fair. This is only the tip of the iceberg when it comes to convertible debt, but hopefully it lays out the basics well enough for you to go into a discussion of convertible debt with some understanding of how it works. You can find more definitions of terms at Ask the VC, which did a great series on convertible debt, or you can always contact us at Early Growth Financial Services for start-up consulting. Are you using convertible debt? Tell us why or why not in comments below or contact Early Growth Financial Services for financial support. David Ehrenberg is the founder and CEO of Early Growth Financial Services, a financial services firm providing a complete suite of financial and accounting services to companies at every stage of the development process. He's a financial expert and startup mentor, whose passion is helping businesses focus on what they do best. Follow David @EarlyGrowthFS. Related Posts:

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