Convertible debt is a valuable tool, especially for very early stage startups. This financial arrangement enables an investor to invest money in your company without negotiating a valuation for your company. These contracts enable the debt to convert to equity when the next round of capital is raised at a specified value. Essentially, convertible debt enables seed investors to leave the valuation work to the next investors.

This can be very helpful for seed stage investments as it can be disadvantageous to set a valuation of the company before the first professional investor gets involved. For example, if the seed stage investors invest at a much higher valuation than the professional investors are willing to do in the Series A, there can be a lot of tension as their equity stake can be significantly eroded.

There are two other significant characteristics of convertible debt worth noting:

• The convertible debt typically converts at a discount to the valuation set in the next investment round. This is commonplace and is generally fair, as the convertible debt investor is exposed to more risk than the next investor since they gave money to the company earlier in its development.
• If an investment is never made in the company, the debt holders often have the option to convert the debt to equity at a pre-determined price or remain as debtors.

In sum, if you are not ready to raise venture capital, raising money through a convertible note is often a desireable strategy.

Comments

[Furqan]

You make a good point, although the two times I've used convertible debt it has created a headache when closing the next round of equity as the cap table is a moving target that changes on a daily basis. One suggestion is to make the coupon payable in cash as opposed to having it convert. That makes doing the deal logistically easier. Also, it's highly recommended to keep the minimum investment to a size where you have a handful of investors....I've seen angel rounds with 30 investors in convertibles and it just compounds the timing issue mentioned above.

[Mark Davis]

Furqan,

You make a fair point. The one caveat is that most VCs won't want to see cash leaving the business in its early stages as access to capital is a driver of growth. In my opinion, the upside of keeping the cash in the company outweighs the downside of calculating interest obligations.

-Mark