Venture Deals, 4th Edition

CHAPTER 8Convertible Debt

In the past few chapters, we’ve gone through the exhaustive, but hopefully not exhausting, terms in a typical venture capital equity financing. As we foreshadowed previously, the popularity of convertible debt has grown over the years. Today, many angel investors and accelerators invest primarily using convertible debt. In the majority of cases, unless the company fails to raise any more money, this is a temporary state of financing, because the debt is intended to convert into equity at a later date.

So, what is convertible debt? Simple. It’s debt. It’s a loan. With a loan, you don’t have to argue about valuation, although you may argue about potential future valuations using the concept of a valuation cap, which we will discuss further on. The fundamental notion is that when a company raises a future round of equity financing, the money loaned to the company via the convertible debt round converts into whatever type of stock the company sells under whatever terms it agrees to in the future. In exchange for the convertible debt, the investors get a modest interest rate and typically convert at a discount to the price to the next 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 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 ...