The Risks and Rewards of Convertible Debt

In recent years, convertible debt has become the most common security used by entrepreneurs to fund early stage companies, particularly tech startups. Convertible debt wasn’t always this popular, and there are more pros and cons to convertible debt than most entrepreneurs know. So in this post, I’ll cover why convertible debt is popular (the pros), what some of the misunderstood downsides are (the cons), and what alternatives exist that might be a better fit for your company.

Convertible Debt in a Nutshell

Legally, convertible debt is debt — it’s a loan to your business. But functionally, when SMBs issue convertible debt it is used in place of issuing equity to angel investors or seed stage VCs. These investors really intend to be equity investors. In this way, convertible debt is essentially “unpriced equity.”

The Technicalities and Mechanics

Convertible debt, when used to fund young companies, generally has the following major terms:

• Interest and payments: A relatively low interest rate (generally 6-9%). Interest accrues (meaning it’s not paid in cash) until the maturity date or conversion into equity.
• Maturity: Generally 1-3 years from when the note is funded. We recommend having at least two years — financing always takes longer than you expect.
• Conversion into equity: When the company has an equity financing round, then the convertible debt (plus any accrued interest) converts into equity. The event that triggers this conversion is typically called a “Qualified Equity Financing” in the convertible note documents, and it will specify certain criteria that constitute a Qualified Equity Financing. Frequently this is an equity financing of at least $1 million dollars (often even higher) that is negotiated with an arms-length third party.
• Discount and cap: Since the investors in convertible debt took an early bet on your company, they get some benefits over the investor who negotiates the true equity financing with you (the one who triggers the conversion of the notes into equity). Therefore, there are two main benefits the convertible notes are typically given:
  • Discount: The convertible debt converts into equity at a lower price per share than the equity investors are purchasing shares. Typically, this discount is 20-30% (25% is probably most common). In other words, if I own a $100,000 convertible note with a 25% discount, and the equity investors buy shares at $1.00 per share, this means I get to buy shares at $0.75, so I get $100,000 / $0.75 = 133,333 shares for my $100,000 note. (This example ignores accrued interest, which typically would also convert into shares.)
  • Cap: If I am an investor in convertible notes, I want to know that you won’t use my money to grow the valuation so amazingly high that the discount doesn’t adequately compensate me for my high risk bet on your company. So we negotiate a conversion cap that defines the maximum valuation at which my note (and accrued interest) will convert into stock. For very early-stage companies, this is often $5 million dollars or less, but there is a huge amount of variation in this — it all depends on what you negotiate with the investors.

The Pros of Convertible Debt

One of the reasons to use convertible debt is that it’s widely known with investors. This is kind of like saying it’s popular because it’s popular. But it’s true. Other reasons to use convertible debt include:

• Easy to negotiate. The only major terms are the discount and the cap. This is much easier than stock offerings, especially if the stock offering will include preferred stock (what VCs typically invest in) because it typically has lots of preferences and protective provisions that need to be negotiated.
• Inexpensive transaction costs. An experienced lawyer that works with startups on financing transactions has stock convertible debt docs, so there’s a good chance the transaction will cost you less than $5,000 in legal fees. For references, a typical VC preferred stock deal will run $15,000-40,000.

The Cons of Convertible Debt

One of the downsides of convertible debt is that you can easily end up with too many early investors, since you’re often getting relatively small checks from angel investors. If this is the caseit can be messy when you bring in an institutional equity investor, who is setting terms for lots of people. Other issues entrepreneurs should be aware of:

• It’s legally a loan. This means the note comes with a maturity date when you owe the money. Life happens and investors may want their money back — you don’t perform, the note holder dies, or whatever reason.
• Full ratchet anti-dilution rights. This is the least entrepreneur-friendly anti-dilution right because when the investment gets converted, it limits the investor’s dilution while entrepreneurs get unlimited downside.
• Multiple liquidation preference. Investors in convertible debt that has a valuation cap are often getting a significantly higher liquidation preference than the cash they invested in the company. A knowledgeable lawyer should account for this in the docs, but all too often we see convertible debt that ends up with unintended multiple liquidation preferences.

To read more, here are two articles I wrote on multiple liquidation preference and full ratchet anti-dilution rights.

What About Other Funding Options?

• A SAFE? This acronym stands for “Simple agreement for future equity.” Targeted for use by early stage startups, the SAFE was introduced by Y Combinator as an alternative to convertible notes.  Like with convertible notes, the investor buys not stock itself but the right to buy stock in an equity round when it occurs.  It can have a valuation cap, or be uncapped, just like a note.  But instead of buying debt, the investor is buying something that’s more like a warrant, so there’s no need to decide on an interest rate or fix a term. It is truly unpriced equity and so is really a better option because it’s not equity in a debt structure. The only problem is that lots of investors haven’t heard of a SAFE.
• Series A or Series Seed round with a VC? Unless you’re Elon Musk or Jack Dorsey, it’s virtually impossible to interest VCs in a Series A round before you can demonstrate significant traction — either revenue or users or another metric that shows product/market fit. So you’ll need to have a viable offering of some sort. However, even with traction, be aware that VCs fund a small percentage of startups. If you read TechCrunch regularly, you’re prone to think everyone with software can get VC funding — that’s not the case. In reality, it’s very, very hard for most companies to get VC funding, and it will probably take you six months to close a seven-figure equity round.
• Revenue-based financing? Revenue-based financing can be an easy and cost-effective way to grow your business, not to mention a way to retain control and equity for founders. The key is you need to have revenue to qualify, since revenue-based lenders get repaid from a percentage your revenue stream — like a royalty.
• Bank loan? Sadly, banks don’t like to fund smaller, newer businesses that lack significant hard assets and profits. That means software companies have a particularly hard time with banks. Even the tech banks, like Silicon Valley Bank, generally won’t offer you credit unless you are VC-backed or have annual revenues over $5 million. So if you’re early-stage, even with revenue, a traditional bank loan is probably not going to happen unless at least one the cofounders is willing and able to guarantee the loan with their personal assets. And if you’re willing to risk your personal assets, you might as well invest in your company directly instead of haggling with the bank and paying interest.

Overall, convertible debt has its pros and cons — just be aware of what you’re getting into when you plan out the funding path for your company. My advice to entrepreneurs is always pay attention to the terms, and always have a good lawyer who frequently does financings for startups. Then you’ll know the devils in the details won’t be making life hell for you.