Definition of Convertible Debt

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Convertible debt is a loan that can be turned into equity usually after securing future financing. Convertible debt attracts savvy start-up investors. It is a way to secure investment funds without needing to present the economic value of a company.

Considerations

When deciding to use convertible debt in your start-up company, be aware of how it works. Understand that it will trigger the conversion of the debt into equity. Most investors usually choose a financing event in which the conversion will occur. A financing event is determined by the company's owner, and could be a particular business milestone or at a point when revenue or financing has reached a particular threshold. You'll want to maintain control of the specific time period in which the conversion will occur.

The investor may receive a discount on shares when the conversion occurs. If the stock price is set too high and there was no limit placed on the discount, the owner of the company may end up paying for the high stock price out of his own pocket. The generous discount that was given to the investor begins to cut into the valued stock price.

If the conversion happens, think about what you'll do with the debt. Should the start-up money be kept as debt? Will the conversion process be set by the investor or by the company at that point?

Pros

Convertible debt is popular with start-up investors because the initial debt can accumulate interest. There is less dilution, or reduction in stock price per share due to the conversion of the securities. The investor may receive a discount on the share price of the stock.

Cons

The convertible debt process is complicated and requires a lawyer and/or a certified public accountant (CPA) who is knowledgeable about the process to explain and help handle the proceedings. Entrepreneurs are sometimes scared to take on a large amount of debt upon the start-up of their company. If they do, investors sometimes meddle and take a bigger role in the start-up proceedings of the company more than should be allowed by the entrepreneur.

Expert Insight

When starting a company by using convertible debt, it is a good idea to have an attorney or CPA assist you so that you and your investors have full a understanding of the deal. In the business plan, clearly outline how the investors will be repaid. To show the investor a secured return on their investment, draw up a financial package detailing the company’s assets and liabilities, the projections of the company’s profits and a cash-flow chart of how monies will be moved in and out of the business.

Conclusion

Convertible debt is like getting a loan from a bank except that both the investor and the entrepreneur understand that the debt will be converted into equity. The founder of the company maintains control of the company throughout the convertible debt process. Convertible debt is a way to turn the investment around quickly so that the entrepreneur can get back to focusing on the business and its customers.

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