What Is a Convertible Debt?
A convertible debt is a type of loan that can be converted to equity/stock ownership after a period of time. The conversion normally occurs at a time when a business requires additional financing.
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Features
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Convertible debt provides a balance between two methods of raising capital: debt financing and equity financing. If certain conditions are met, remaining debt can be converted into an ownership stake.
Benefits
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While investors may be unwilling to lend a large amount of money via a traditional loan, convertible debt gives the lender an opportunity to turn the loan it wrote into an equity stake in a growing company.
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Potential
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Convertible debt allows investors to provide startup funds, all without needing to settle on a valuation of the company in which they are investing, as would be necessary with equity financing. Convertible debt also gives the business owners an opportunity to establish their business before settling on a valuation that may be too low.
Expert Insight
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Entrepreneur.com notes that traditional loans are the most effective route of financing for a firm with low startup costs, but that convertible debt can entice investors if a large amount of venture capital is necessary.
Warning
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A business may require a lawyer to draft the terms and conditions of a convertible debt financing loan. The business owners are also responsible for deciding and communicating with the lawyer what event will trigger the debt-to-equity conversion.
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