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Understanding Convertible Debt Financing

What is Convertible Debt?

Convertible debt, often referred to as a convertible note, is a short-term loan that converts into equity at a later date. Here are some key features of convertible debt:

  • Loan format: The investment is structured as a loan, meaning the company borrows money from investors that they will need to pay back with interest.
  • Conversion to equity: The loan converts to equity shares in the company when a later round of financing occurs. This is usually tied to a future event like a Series A financing round.
  • Discount on conversion: Investors typically get a discount of 15-30% on the share price when the loan converts to equity. This compensates them for the higher risk of investing early.

In essence, convertible debt allows a company to delay assigning a valuation while raising needed capital quickly. The investors gain the advantage of locking in the investment at an early, usually discounted rate, in exchange for the higher risk they take on the company’s future potential.

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Why Use Convertible Debt Financing

There are several key reasons a startup may choose to use convertible debt financing:

Speed and flexibility

  • Raising a convertible note can typically be done much faster than a priced equity round. This enables startups to quickly raise funds needed to grow.

Avoids setting a valuation

  • Setting a valuation early on can be difficult for very early-stage startups that may have a lot of uncertainty around their business. Convertible notes allow them to delay setting a valuation until a future financing event occurs.

Investor friendly

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  • The discount and loan aspects appeal to investors compared to just purchasing equity. Converts also do not dilute existing shareholders until conversion.

Simpler structure

  • The legal and documentation costs of a convertible note round are much less than a priced equity round. Most note rounds have standardized templates.

Convertible debt is not ideal for every company, but it can be the right solution for early-stage startups needing quick financing and flexibility on valuation.

How Convertible Notes Work

When a startup raises funds via a convertible note round, the basic process goes as follows:

  1. Note terms established
    • Terms like the valuation cap, discount rate, and maturity date are set. The valuation cap sets the maximum valuation where convertible notes will convert.
  2. Investors invest funds
    • Investors invest money into the startup. Their investment is essentially a loan to the company that will later convert into equity shares.
  3. Company makes interest payments
    • The startup will make periodic interest payments on the notes per the loan terms until conversion. Rates are usually 6-8%.
  4. Notes convert to equity
    • The notes convert into equity shares in the company when a trigger event occurs, like a Series A financing round. Investors get equity at a discounted price in exchange for their investment risk.
  5. Loans are repaid if not converted
    • If no conversion trigger occurs by the maturity date, most notes will simply convert into equity using the valuation cap, or they may also be repaid like a loan with accrued interest.

This structure gives flexibility to both the startup and the investors throughout the process. At conversion, the risk taken by investors is rewarded through the discounted equity price.

Pros and Cons of Convertible Notes

Pros

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  • Faster to close and lower legal costs than priced equity rounds
  • Delay setting a valuation while still getting growth capital quickly
  • Investor friendly structure with discount and loan aspects
  • Allows founders to minimize dilution until a priced round
  • Easier to negotiate terms compared to a priced round

Cons

  • Higher interest rates than traditional debt instruments
  • Risk of very high dilution for founders if valuation rises steeply
  • Complex financial structure with debt and equity aspects
  • Possibility of “stacking” if multiple notes accumulate
  • Lack of investor voting rights until conversion

As with all financing options, there are tradeoffs to evaluate. But for the right startup, the speed and flexibility of convertible notes can outweigh the negatives.

Key Terms in Convertible Notes

When looking at a convertible note term sheet, there are certain key terms that founders should understand. These include:

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Valuation cap – The maximum valuation where convertible notes will convert into equity. This benefits investors.

Discount – The % discount investors receive on the share price when the notes convert. Usually 15-30%.

Maturity – The length of time before the note expires and must be repaid if not converted. Typically 1-2 years.

Interest rate – The % interest rate the company pays on the loan until notes convert or repayment. Typically 6-8%.

Conversion trigger – The event that triggers automatic conversion from debt to equity, like a Series A round.

These terms allow investors to get compensated for their early risk while capping the potential dilution for founders. Understanding the implications of each is key during negotiations.

Alternatives to Convertible Notes

Convertible notes are one of several early-stage financing options startups have. Common alternatives include:

  • SAFE Notes – Similar structure but no interest payments. May be more founder friendly.
  • Equity Financing – Priced equity rounds that set a valuation and issue shares upfront.
  • Debt Financing – Raising funds via business loans or credit lines instead of issuing equity.
  • Revenue-Based Financing – Investors provide growth capital repaid through a % of revenue.
  • Grants & Accelerators – Equity-free funding from governments, non-profits, & accelerators.

Founders should explore all options, weigh the pros and cons of each, and determine what type of capital best fits their current business needs.

Key Takeaways on Convertible Notes

  • Convertible debt enables startups to raise funds quickly without setting an official company valuation.
  • Investors loan money that converts to equity shares in the future at a discount price that compensates for risk.
  • Convertible notes can provide speed and flexibility between founders and investors early on.
  • Key terms establish the future conversion details and reward investors for their risk.
  • Alternatives like SAFE notes, equity and debt financing may fit some startups better.

Convertible notes are never a one-size-fits-all solution, but can be an effective bridge to support startups needing capital to accelerate growth in the short term. Founders considering convertible debt should enlist advisors to ensure they negotiate fair terms that balance both company and investor incentives.

I hope this overview has provided a helpful introduction to convertible debt financing and key factors to evaluate when considering raising a convertible note round. Let me know if you have any other questions!

Resources

Articles with More Information

Videos Explaining Convertible Debt

Example Convertible Note Documents

Let me know if any of those resources are helpful or if you need any clarification or have additional questions!

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