A convertible debt, also known as a convertible note, is a type of short-term loan that can be converted into equity, typically during a subsequent financing round. It's a financial instrument often used by early-stage startups when they first begin raising capital.
Here's how it generally works:
Initial Loan:
An investor lends money to a startup, and instead of receiving a straightforward loan with an interest rate and maturity date, they receive a convertible note.
Conversion to Equity:
When the startup raises a future equity financing round (e.g., a Series A round), the loan converts into equity at a specific conversion rate. The conversion rate is often determined based on the price per share in the new financing round, possibly with a discount or a valuation cap to provide an incentive for the initial lender.
A discount means that the convertible note holder can convert their debt into equity at a price per share that's lower than what the new investors are paying. A valuation cap sets a maximum company valuation at which the note will convert, providing a potential upside if the company's valuation at the new round is higher than the cap.
If Conversion Doesn't Occur:
If the startup doesn't raise a new round before the maturity date of the note, the startup would typically have to repay the loan, often with interest. However, in practice, the terms may be renegotiated, or the note might convert at a predetermined valuation.
Convertible notes can be advantageous for startups, as they allow them to obtain initial funding quickly and without having to negotiate a specific valuation. For investors, convertible notes can provide a way to support a startup at an early stage while potentially benefiting from a discount or valuation cap if the startup succeeds.
