Convertible Debt Financing for Your Startup

01/21/20 | 6 MIN READ

Convertible debt financing is available through both VC firms and angel investors.

Funding your startup is likely going to be among the largest hurdles that you'll face when attempting to start and grow your company. However, there are many fantastic methods that you can use to obtain financing for your startup. When you're in the pre-seed and seed funding stages of financing, you should heavily consider looking into the possibility of investments from angel investors. If you can find an investor who's interested in financing a company like yours, they can provide you with the money you need to hire new employees, begin product development, and expand your business.

When your primary goal is to grow your startup, venture capital firms may be able to provide your startup with a significant amount of financing that could give you the money needed to expand into other regions or begin development of multiple products. It's important to know and understand the various types of financing available to you because your chances of success can increase substantially if you tap into these forms of funding. Different types of financing are also meant to be used at different stages of growth.

One type of financing that you could look into is convertible debt financing, which gives you the ability to quickly raise large amounts of money even if your company doesn't have a valuation.

Convertible debt financing is available through both VC firms and angel investors. If you're in the midst of weighing all of your financing options, the following offers an extensive guide to convertible debt financing and how it can benefit your startup.

What is Convertible Debt Financing?

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  • Convertible debt finance is a unique type of financing that's issued directly by the startup when they are trying to raise funds during the seed round of investments.

With this type of debt, the startup provides the seed investor with a promissory note that includes the exact investment amount and a conversion feature to be used at a later date. Once the startup has reached certain milestones, the promissory note will convert into equity, which usually involves shares of the company. The conversion typically occurs when the startup in question has obtained a certain amount of Series A financing.

There are several reasons that startups use this method of financing, the primary of which is that startups gain the ability to raise funding quickly without having first received a valuation. For investors, this option of financing is ideal because it allows investors to gain shares in the company at a lower cost than is available once the startup begins to raise Series A financing. At this time, the valuation of the company will have undoubtedly made the shares cost more for any new investors.

If you have had difficulties raising standard financing for your company, convertible debt financing may be the right option for you.

Convertible Equity

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This is a newer form of security that provides startups in the early stages with the ability to receive flexible financing. The main difference between convertible debt and convertible equity is that the convertible equity doesn't need to be repaid to the investor.

It's also important to note that convertible equity doesn't accrue interest, which is another notable benefit of using this type of financing. Despite these differences, convertible equity is used in the exact same situation as convertible debt financing, which means that you can opt for this form of financing during the seed round of funding.

What Makes Convertible Notes So Popular?

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Convertible notes are promissory notes that are used for either convertible equity or convertible debt financing. These notes are unique in that they provide investors with a written promise that the exact investment they receive can eventually be converted into equity via shares of the company. Investors choose to use convertible notes because they significantly decrease the risk associated with investing in a startup while they are still in the early stages of financing.

Convertible notes are considered to be popular because they offer two distinct benefits.

  • For one, the investors and founders of the company are able to postpone discussion of the startup's valuation, which is an estimation of the company's worth. These agreements can also be drawn up at a much quicker rate and at a cheaper cost when compared to standard equity deals.
  • The use of convertible notes makes the financing process much more straightforward. The notes can only be converted into equity when the startup in question has progressed to the Series A round of financing, which means that the startup will be in a healthy position of growth.

Pros and Cons of Convertible Debt Financing for Startups

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While convertible debt financing is considered to be highly beneficial for both startups and investors alike, there are numerous pros and cons that every startup should be aware of before using this form of financing.

The benefits of using convertible debt financing include:

  • This form of financing is widely used and accepted by investors, which means that it shouldn't be too difficult to convince an angel investor to use this type of financing
  • The only major terms of convertible debt financing include the discount, cap, and interest rate, which means that this financing is easy to negotiate
  • These transactions have less costs than stock offerings
  • The legal fees for a convertible debt transaction are usually less than $5,000, which is much lower than the $20,000-$40,000 that occurs with venture stock deals

The cons of convertible debt financing include:

  • If you want to bring in a large amount of angel investors, it can be difficult to keep track of all the convertible notes that you need to create
  • If your company doesn't reach the Series A round of financing, you will need to pay back the entirety of the investment once the loan has reached maturity
  • Investors are able to obtain shares in your company that are 15-25 percent cheaper than they would cost after market valuation

Because of the various methods that a startup can use to raise funding during the early stages of their growth, it's essential that you understand each of the aforementioned points so that you can be confident that your final financing decision is the right one.

Once you've decided to use convertible debt financing to raise funding for your startup, this financing will be the main focus of the seed round of funding.

How Convertible Debt Works

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The primary aspect of convertible debt financing is the convertible note that needs to be created and issued by the startup to the main investor. Most of these notes come equipped with a clause of automatic conversion wherein the debt converts to equity for the investor once your startup has reached qualified financing, which usually occurs during the Series A round of funding. It's at this point that investors will purchase shares of the company in order for the startup to raise additional capital that will aid them in growth.

Convertible notes also come with a discount feature for the investor that usually places the price per share at around 80 percent, which provides the investor with a 20 percent discount of what the shares will cost during the Series A round of funding. Keep in mind that these loans typically mature in 1-2 years, which gives you a short period of time to advanced to later rounds of funding. As such, it's recommended that you're confident about the growth of your company before you use this option of financing.

The process of obtaining convertible debt financing depends on how long negotiations take between you and your investor. Since these negotiations only involve setting such terms as the cap amount, interest rate, and discount, they are typically completed in a much shorter time-frame when compared to stock offerings. Once the terms have been agreed upon and the startup has issued the note to the investor, the startup will be provided with the investment amount that's stated on the convertible note.

When Would Startups Typically Use It?

standing man looking at as his watch

Your startup should consider using convertible debt financing during the seed round of funding, which is considered to be the first equity funding stage.

Seed funding is designed to help startups finance their first steps, which typically include product development and market research. At this point in time, it's likely that you will only have an idea for a startup instead of a complete product. The majority of startups never reach latter stages of funding such as Series A funding. However, obtaining funding via convertible debt financing may allow you to grow your company and bolster the chances of success.

The types of investors that you can use a convertible note with during seed funding include:

  • Other founders
  • Family members
  • Friends
  • Venture capital firms
  • Angel investors

These individuals and companies may be more likely to provide you with their money if you use convertible debt financing, which allows them to invest in your startup without incurring much risk with their investment portfolio. If you want to grow your company and believe that you have an idea that can be impactful once on the market, you should at least consider this method of financing.

Using Convertible Debt Financing for Startup Success

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If you're having difficulties convincing investors to provide funding for your startup, convertible debt financing is a great way for you to raise money quickly without much risk. While these investments will need to be paid back when the loan reaches maturity, the note will simply be converted into company shares if your startup reaches the Series A round of financing. Because of how widely used convertible debt financing is among angel investors, these investors may be more likely to provide you with funding if you use a convertible note.

Since this type of financing is used before a company valuation, convertible debt financing gives you the ability to delay valuation while you focus on product development and market research. Once you obtain these funds, you can get started on your next stages of growth without needing to worry about anything else.

If you want to start product development or market research soon after you receive seed funding, you can do so with the assistance of University Lab Partners, which is a wet-lab incubator that's ideal for life science startups that need office and lab space but don't want to spend too much of their budget.

You can apply today to join this incubator and gain access to the space and equipment you need to grow.


Revised 11/16/2020


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