When starting a business, entrepreneurs often consider either debt or equity as sources of capital. They often aren't aware of another type of financing—convertible debt.
Convertible debt is a loan from investors that turns into equity at a pre-determined time in the future. This financing tool works best for first, or seed, funding, which usually ranges from $50,000 to $500,000. The funds are used to launch the company and support it through the initial stages of development. Once the company receives the second round of funding, the debt is converted to equity, giving the investors a share of the company. If all goes well, their investment will have a higher value than their initial outlay. Interest is also accrued.
Creating a convertible debt agreement is easier and less costly than setting up a capital investment round. In contrast to the disclosures and paperwork needed to create an equity offering, debt term sheets and closing documents are simple to execute. Boilerplate loan documents can be used as a basis. Legal fees associated with loan agreements are much less expensive than with equity deals. In addition, the time to set up the deal is much shorter than with equity, which means receiving cash and getting underway sooner.
A major advantage of convertible debt is the ability to avoid premature business valuation. When using equity investors, a percentage of the company is assigned to their ownership. In the early stages, especially pre-revenue, it can be difficult to determine the worth of the business. Later investors might set a value that is too low, eroding early stage investor equity. Conversely, setting the value too low at first may affect the price of future stock offerings.
Founders retain control with this type of financing, since investors don't initially own a piece of the company. This keeps owners' options open, like selling the company and paying off the debt. Debtors don't usually get a seat on the board of directors, which means they don't have a vote in business decisions.
Convertible debt terms usually include discounts to investors once the debt is converted. A common discount range is 20-25%, which means that investors receive additional equity during the next round of financing. For example, if the discount is 20% and they invested $1 million, their equity would become $1.25 million. At that point, the business owner is released from obligation to repay the debt. If investors are concerned that a high value in a future round will dilute their ownership, conversion caps may be set or their proposed discount rates may increase.
With the specific benefits it provides to entrepreneurs looking to get their business up and running, convertible debt should be considered alongside debt and equity as a potential source of needed capital.