Breaking Down The Myths About Convertible Debt

This article will take you 6 minute(s) to read

In this insightful guest blog, Stefani Bozadzhieva from leading valuation platform Equidam explains the pros & cons of convertible debt. You have probably heard of the concept of convertible loans. Quite frequently convertible debt is considered the better or even easier financing option compared to raising an equity round. Is that really the case?

First things first, if you think you need a quick refresher on what convertible debt is check out this video.

Has convertible debt really won?

These are two of the most frequently mentioned advantages of convertible debt over equity. Let’s take them one by one.

1| Immediacy 

Issuing convertible debt is quick because you do not need the approval of a notary. You can just draw up a contract for the investor to sign. So it is a very good way to cash in. In most cases, at least in the US, convertible notes are not part of a round so they are issued at any time. Any investor can enter just by signing the note and you – as a founder,  can get the cash-in immediately.

However, it is extremely difficult to find an investor that will take that leap of faith initially, without knowing that other investors will do the same. It is difficult to issue convertible debt that is not part of a round, because investors are aware that your company probably needs more money than they are offering. So the risk that their investment will be wasted is higher.

In case the convertible note is part of a round, most of the investors will not invest unless everyone else commits and you reach your funding goal. So the immediacy is lost.

2| Cheap 

You are simply drawing up a contract that does not need the approval of a notary. The reason is that you are not actually issuing the shares at the moment, which saves you the legal fees. Once you have the template ready and you have negotiated the terms of the note – the maturity, the cap, etc, the contract is good to go.

Unless you already have shareholders – so your company is comprised of more people than you and your co-founders. Since convertible debt is a type of hybrid security – meaning that it will convert into equity at a trigger event, you need the approval of all the shareholders. This can be quite expensive, because in this case certification of a notary is required.

To sum up, issuing convertible notes is more suitable for quick finance injections rather than full financial rounds. It also seems to be much more popular in the US – where it originated.

There are online platforms in Europe that facilitate the fundraising for startups using convertible debt as a tool. In this case, the investment can be as immediate and instinctive as in the US.

When negotiating in the offline investment arena, convertible notes are not as intuitive as they are supposed to be. As a result, the above mentioned advantages are in fact neutralised.

Convertible notes pitfalls

While the US was introduced to the concept of convertible notes in 2009-2010, in Europe they were just recently  introduced. There might be investors that are not familiar with the concept or not comfortable with it. You may also experience some difficulties in finding a professional firm that knows how to deal with the legal implications of a convertible note.

Convertible debt is a type of hybrid security that can seriously affect your cap table at the time when it converts. At your next funding round, debt holders become shareholders. This way your early investors might receive a larger stake in the company than initially agreed upon and also a much larger share than the current investors.

This could create conflict in case a VC does not feel comfortable with the conversion terms. Most investors will tell you that this doesn’t matter and that if they want to invest, they will do regardless of the convertible note.

The complexity of the note will also cause higher legal costs when the debt is converted to equity. Sometimes the structure of this type of security is so complex that it could make investors uncomfortable.

Finally, investors that become part of a company through a convertible note might feel detachment from the organisation in general.

Breaking down the myths about convertible debt

It seems to be a common idea that convertible debt is not priced and by issuing it you skip the negotiations about the price of your company. That is not true!

Convertible debt usually comes with a cap. If it doesn’t, we are talking about full investors. If there is no cap, the investors will convert at the next priced round at the same valuation that the investors from the new round will pay.

For example, if you raised money from a small angel investor when you started your company, he will convert at the same valuation of the VC firm that is leading your funding round today.

If you do have a cap, it represents the maximum valuation that the group of investors is willing to pay for your company at the moment of the contract.

In this case, we are already talking about the valuation. So instead of talking about the maximum valuation the investors are willing to pay for a convertible note, why not start the conversation about the minimum valuation they are willing to pay and have a priced round?

Negotiating is good, because it helps you to get the feeling of the other person. So founders should not be scared to negotiate and discuss about valuation and capital.

Bottom line is that you are already talking about the valuation, so does it makes sense to use convertible debt?

If you want to see relevant data for pricing a convertible note check out Equidam’s convertible note calculator!

If you want to learn more about the differences between convertible debt and equity financing, check out the below video:

What is your experience with convertible debt? Did you have any difficulties or, on the contrary, you were well aware of the plus and minus sides? Share it in the comments!