Startup funding – What is convertible debt?

by | May 23, 2014 | Securities, Startups, Threshold bLawg

Getting funded

When we work with our startup clients, the topic of funding comes up often.  “Do we try to raise money now?  How do we know how much the company is worth?  We are doing great things, but the revenue is slower and lower than we would like.”

For early-stage startup funding, one early funding option is convertible notes.

Among other benefits, a convertible note allows you to postpone the valuation decision and negotiation until further down the road.  The fact is, nobody really knows what a new company is worth.  So if you get bogged down with potential investors discussing whether their $250,000 is worth 10% of the company, 50% of the company, or 100% of the company, nobody is right, nobody is wrong, but everybody is stuck.

Convertible notes start out their lives as loans, documented by a promissory note (a legal document that is a promise to repay a debt).  The note is called “convertible” because it may later be converted into an ownership stake in the company.  When and how?  By a later round of investment.  When the agreed-upon amount of later investment comes in, the convertible note converts into an ownership stake.  The price of the shares is defined by the later investment transaction.

For example, an investor might buy a $100,000 convertible note, paying 8% interest.  The conversion trigger might be set to happen when (and if) there is a later $1 million or greater equity investment, and the convertible note investor may get a 10% discount but otherwise will have its debt converted to part ownership according to the terms of that later investment.
If a $1 million or more equity financing happens during the life of the note, the convertible note investor will have its principal and interest converted to equity at 90% of the share price established by the later $1 million transaction.  So when the later $1 million investor gets 20% of the company for that $1 million, the $100,000 convertible debt investor gets not just 2% ownership, but a little more than 2% because of the 10% discount and some interest that will have built up.

Next week’s post:

Why does it take so many pages of documentation and legalese to take these investment dollars? What are we, Google?