Simply put, convertible debt is debt you can covert to equity. Convertible debt financing is much like a traditional loan in that a company borrows money from angel investors, friends, and family or even venture capitalists, and promises to repay it with interest by the end of the term of the loan. Convertible debt financing is often called “bridge” financing, because it provides a company with the capital it needs to continue operations until the next round of venture financing takes place.
To compensate a convertible debt investor for the added risk of early investing, the conversion to equity is typically given at a discount to the price being paid by venture capitalists (usually around 20-40 percent), or the convertible debt investor receives a warrant to purchase additional shares of the equity into which the principal and interest on the loan will convert in the financing.
Unlike a traditional loan, however, the entire principal of the loan, as well as the accrued interest, will convert to equity at the option of the lender or will do so automatically when certain events occur. For example, if the company raises a round of venture financing, the outstanding principal and interest usually automatically convert into equity of the same type as is being sold to the venture capitalists. By tying conversion to a financing, the debt holders are piggybacking on the valuation determined by the equity investors.
The most significant advantage that convertible debt offers to early stage companies is that it is a simple transaction and, therefore, costs less to complete than equity financing. This reduced cost can be quite significant. If your company is only raising a small amount, then these savings can be critical to your company’s success.
Although convertible debt starts out as a loan, it is still considered a security. As such, all the normal securities laws apply, including the restriction of sales to non-accredited investors. A corporate attorney experienced in securities can guide your company through this process.