- So what is convertible debt?
Convertible debt financing is basically an investor loan to your startup that has a future conversion-to-equity feature. That is, your startup’s investor gives your startup a loan like a bank would, but the outstanding balance of this loan will convert to shares in your corporation at a future date.
2. When does convertible debt convert to equity?
Convertible debt typically converts to equity the next time your startup raises capital (think venture capital or similar large investor). Technically, this large raise is called a “qualified financing” per the convertible debt agreements (note and note purchase agreement).
3. How does convertible debt convert to equity?
Convertible debt converts to equity based on the valuation your startup receives from the venture capital firm in the “qualified financing.” For example, if your venture capital investor ends up paying $1 per share for your startup’s preferred stock and you have $800,000 of convertible debt, the investor will receive 800,000 shares of preferred stock. The loan will then be cancelled. (Note: Convertible debt often converts to preferred stock at a discount than what the venture capital investor pays for the preferred shares.)
4. But what happens to the convertible debt if you sell rather than raise capital?
In this unique situation, the startup essentially skips the “qualified financing” and goes straight to the exit.
In most situations, the investor will receive more than the interest due + principal balance of the loan; perhaps anywhere from 1.5X-3X the outstanding principal amount of the loan.