In the past few chapters we’ve gone through, in detail, the terms in a typical venture capital equity financing. However, there is one other type of financing, often used at the seed stage, called a convertible debt financing. In fact, many angel investors will invest only with this structure.
Convertible debt is just that: debt. It’s a loan. The loan will convert to equity (preferred stock, usually) at such time as another round is raised. The conversion usually includes some sort of discount on the price to the future round.
For example, assume you raise $500,000 in convertible debt from angels with a 20% discount to the next round, and six months later a venture capitalist (VC) offers to lead a Series A round of a $1 million investment at $1 a share. Your financing will actually be for $1.5 million total, although the VCs will get 1 million Series A shares ($1 million at $1 per share) and the angels will get 625,000 Series A shares ($500,000 at $0.80 per share). The discount is appropriate, as your early investors want some reward for investing before the full Series A financing round comes together.
In this chapter, we cover the arguments for and against using convertible debt. We then go through the terms in a convertible debt deal, including the discount, valuation caps, interest rate, conversion mechanics, conversion in a sale of the company, warrants, and other terms. We briefly cover the differences between early-stage and late-stage dynamics ...