Convertible Debt in Plain English

Killing us softly with jargon

Finance is a bit like a secret society in that it likes to obscure commonsense ideas with intimidating language. Loans become bonds, bond insurance becomes credit default swaps. It’s a way to separate insiders and outsiders and raise a protective moat around in-the-know practitioners.

Anyone who reads TechCrunch has heard of the term “convertible note,” and knows it’s a common way for early-stage investors to bet on startups. But it’s a hard-to-grasp term, even for someone like me with an economics degree and a year of an MBA under my belt. I recently learned exactly what it does and why it’s used so frequently, and wanted to share that knowledge in a no-bullshit way. It’s not super complicated, but if you’re a 22-year-old Y Combinator grad building your first company, and investors start making offers, don’t you already have enough on your plate without having to parse financial gibberish?

A convertible note is debt. It’s a loan. The details differ, but usually when someone writes you a convertible note for $100,000, you’re expected to pay it back, along with some interest, in 1-2 years.

But of course, no one really wants that to happen. That’s because of the “convertible” part of the note. The investor is hoping that instead of getting paid back, your company will become the next Dropbox or Airbnb, and at some point you’ll raise a real round of venture capital. At that point, the note will become equity, and instead of having the right to get paid back, the investor will have an ownership stake in your company.

Why do a convertible note instead of equity? In short, it’s simpler, cheaper, and less time-intensive than an actual equity investment. For one, an investor and an entrepreneur don’t have to negotiate the value of the company if they’re using a convertible note - they can let the valuation be set during the first equity round. This is particularly useful for really young companies with one or two people and little more than an idea.

Also, if an investor decides to buy 10% of your equity outright, you may need to become an LLC or a Delaware C Corp. There are costs and tax obligations that go along with that. In general, the costs associated with a note can be 1/10th or less that of equity financing ($500 versus $5000, say). Also, if you’ve taken an equity investment and then go bust a year later, it’s difficult (legally) to disentangle all the ownership stakes. If someone loans you a convertible note and you go bust, an investor can simply write off the investment.

Of course, as with all simple ideas, people have figured out ways to make them far more complex. As a founder, there are a couple key sticking points you need to know about:

• The cap. Notes often have a cap, which means, “This is the maximum valuation that my investment will convert at.” Let’s say an investor gives you $100,000 through a convertible note with a $1 million cap. That investor now owns a minimum of 10% of your company. If you raise venture capital at a $10 million valuation, your convertible note holder still gets 10%, i.e. $1 million worth of equity. Of course, if you raise money at a $500,000 valuation, then your note holder gets $100,000 / $500,000 = 20%. In other words, higher caps (or better yet, no cap) are better for entrepreneurs.
• The discount. Another common element of a convertible note is a discount. This is kind of like a floating-rate cap. It basically means that, whatever the value of your company when you take your first equity investment, I get to invest as if it’s happening at a lower valuation. So if a $100,000 note has a 25% discount, and you raise money at a $1 million valuation, your note holder gets $100,000 / ($1 million * 0.75 = $750,000) = 13.3% of your company (rather than 10%). Sometimes a note will have both a cap and a discount, and give the note holder the right to convert at the lower of the two valuations. In general, an entrepreneur prefers less of a discount (or no discount).
• Auto-conversion. You received an investment in the form of a convertible note. A couple years go by as you toil to build your company. The note comes due, and you still haven’t raised a round of equity financing. What now? Most often, the investor will simply extend the note. Or, if it looks like you’re heading toward bankruptcy, the investor might write-off the note and consider it a loss. There’s an interesting third case, though. Maybe your company is doing fairly well, but you don’t need to raise more money. In this case the investor can choose to convert the note into equity… but at what valuation? Hopefully you can agree on one, but if you can’t, the investor holds a trump card: He or she can demand that you repay the note (remember that it’s still technically a loan!). If you don’t have the cash, you go bankrupt – even if the company is otherwise doing well! It’s far better to have some kind of auto-conversion option so that, if after a certain period of time you still haven’t raised additional money, the note auto-converts at a pre-specified valuation. Of course, this requires talking about valuation when the note is written, which eliminates some of the advantages of a convertible note.

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Note: Cross-posted on my website.