Convertible Debt:
How It Works, 9 Common Terms

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Convertible Debt: How It Works

Convertible debt, also known as a convertible note , is a way for start-ups and other businesses to inject capital into operations, typically in the form of a short-term loan that is repaid in cash with the remainder converted into equity. Please review the terms and conditions of a convertible debt note with start-up lawyers or securities lawyers to help you clarify the legal and financial implications associated with it.

What Is Convertible Debt?

Convertible debt is a short-term loan that also carries an issuance date, interest rate, and date of maturity. Borrowers can repay them with cash like any other type of debt upon maturity. Convertible notes are unique in that they are can also be compensated with equity instead of money.

They were developed for use by start-ups without a business valuation to raise capital faster than traditional methods. Typically, investors offer start-ups private loans on the contingency that the debt will eventually convert to stock ownership in the company.

Types of investors may include:

  • Venture capitalists
  • Angel investors
  • Private investors
  • Non-profit organizations
  • Specialty financial institutions

Convertible debts are a quick way for founders to receive a loan without short term payments in exchange for cash. The terms of convertible debts are favorable in that owners get a fast, inexpensive injection of money that they exchange for equity. Ensure that you understand how convertible debt works before establishing the offered terms and conditions to venture capitalists and investors.

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How Convertible Debt Works

The structure of convertible debt primarily centers on the parties involved, industry, and amount borrowed. There are a few calculations that you can use as a start-up or investor to help you determine the amount of stock or equity to issue when facilitating this type of transaction.

Four elements that primarily affect the stock shares provided includes:

  • Remaining convertible debt balance
  • Company valuation at the time of maturity
  • Number shares outstanding and issued
  • Applicable conversion discounts
  • Use of conversion caps on the loan
  • Other factors that affect the terms and conditions

When using convertible debt, the start-up will issue the venture capitalist or angel investor a promissory note that outlines the terms and conditions of the transaction, including converting debt. Speak with a venture capitalist lawyers to help you add the conversion feature to your convertible debt note.

Convertible Debt vs. Equity

There are two ways that companies raise capital: debt or equity. There are significant differences between these two types of instruments, which means that you should carefully consider your situation before engaging in a business transaction to obtain capital. Consider how equity investments are different from convertible debts below since the choice carries specific implications.

How Equity Investments Are Different from Convertible Debts

When engaging in equity finance, angel investors purchase stock from the company in a priced round. The investment made is a percentage of the company and based on current company valuation. Typically, angel investors purchase preferred stock shares, which offer greater privileges than those compared to common stock shares.

Instead of paying back investors in cash with the remainder converted into equity, it is an equity investment for the angel investor while the company gets the capital they need to operate.

Determining If You Need Convertible Debt vs. Equity

Establishing whether you want to raise on convertible debts vs. equity largely depends upon the start-up. Founders and owners should consider the advantages and disadvantages of convertible debt before finalizing the decision. Speak with security lawyers to help you decide since the wrong type can later result in legal problems.

Advantages and Disadvantages of Convertible Debt

As more entrepreneurs turn to convertible debts when raising capital, there are significant advantages and disadvantages to consider. Although it may feel like a straightforward process, the deal structure can become complicated quickly, and you must understand the nuances of convertible debt to make sound decisions that support your company’s longevity.

Consider the following advantages and disadvantages of convertible debt below:

  1. Convertible debts are relatively uncomplicated and straightforward in structure. However, they can also become more complicated after numerous financing rounds.
  2. The pre-valuation investment process can become contentious due to the variables associated with a priced round. Convertible notes allow founders to defer valuation negotiations until later.
  3. Investors can be averse to convertible notes since it may be challenging to establish whether the terms and conditions are fair to the investor. They are typically concerned about voting, control, liquidation, and pro-rata rights.
  4. Noteholders feel like they are at the mercy of others without any direct way of influencing the investment outcome.
  5. The best advantage of convertible debt for the start-up is found in how streamlined the process is. The standardization reduces costs, saves time, and minimizing priced round complexities.

As you can see, there are several facts and circumstances that both the founders and investors need to consider before executing a transaction or agreement. Familiarizing yourself with common terms for convertible debt will help you lay the groundwork for obtaining capital while setting expectations for the future process.

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Common Terms For Convertible Debt

There are several moving parts of convertible debt. You can keep track of them by inputting the terms and conditions into a convertible note or promissory note. Understanding what to include, including common terms, will help you prepare for the transaction.

Common terms for convertible debt include the following:

  • Interest rates : The interest rate for convertible debt is anywhere between four and eight percent.
  • Maturity date : Most convertible debts mature within two years.
  • Mandatory conversion : Mandatory conversions describe the minimum size of the round that must be closed in the future to convert the debt to equity.
  • Optional conversion : This provision gives investors a chance to convert remaining equity securities into the next financing round even if it does not meet the qualified financing definition.
  • Change of control : Use this provision to address what will happen if the founders sell the company before the note converts.
  • Conversion discount : A conversion discount is for the discount received by noteholders related to the qualified financing’s equity price.
  • Valuation caps : This term describes the maximum pre-investment value used to convert the note.
  • Amendment provisions : This allows the company to amend the terms and conditions of the note.
  • Attorneys’ fees : This term establishes that prevailing parties receive attorneys’ fees from the other party if a legal dispute arises.

Before establishing the agreement’s particulars, it is not uncommon for either party to present a terms sheet for negotiation and discussion purposes. You can use it as a beginning point for these activities. It would help if you also worked with an attorney to help you draft this document as well.

Convertible Debt and Start-ups

When it comes to convertible debt and start-ups, it is vital to weigh all of your options with a legal professional. Doing so will help you avoid company-changing mistakes, raise more money , and prepare for a brighter financial future. This choice is a critical one, which means that it is vital to get it right the first time to protect your company’s longevity and performance.

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