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Basics of Convertible Debt Financing

Sometimes a company will want to engage in one or more rounds of seed or venture capital (“VC”) financing. In this post, we discuss the basics of convertible debt financing, which is a commonly used type of financing in seed and early stage deals.

Convertible Debt Financing

Convertible debt is usually short-term debt issued by a company in the form of a loan that converts into shares of stock if and when the company receives VC funding (typically a single investment > $2M USD). In other words, investors loan money to a startup as its first round of funding. However, rather than the investors simply receiving their money back with interest (as would occur with an ordinary loan), they receive shares of [sometimes, preferred] stock as part of the company’s expected Series A or later financing, usually at a discounted price. The discount is offered to provide incentive for investing in a company at an early stage when the probability of the company succeeding is often at its least certain.   At the same time, the benefits of a convertible note to the company include that the company need not subject its corporate governance and streamlined operations to the will of [more] outside shareholders, and the company can avoid the legal and administrative cost (>$10,000) of more complicated securities transactions.

Because the interests of the founders and investors are not perfectly aligned in an equity financing (i.e. the lower the valuation, the higher stake the investor receives for his or her investment, short term versus long term strategies, etc.), a substantial amount of negotiation may be required to arrive at a good deal.  Also, practically speaking, it often makes sense to delay valuing a company until the Series A round of financing because, at that time, there will be considerably more information about the company and its worth, not to mention how expensive it can be to obtain a legitimate valuation.

Another significant advantage to the company of issuing convertible notes is to avoid giving the investors any control in the company. When investors receive shares of preferred stock, they are typically granted significant control rights, sometimes a board seat and/or veto rights with respect to certain corporate actions (known as protective provisions). They also have certain rights as minority shareholders under applicable State law and receive certain economic rights, such as a liquidation preference. Convertible noteholders are rarely granted any control rights and have no minority stockholder rights.  These rights vary depending on whether the corporation is subject to California and/or Delaware law.

In a future post, we will discuss setting a cap on the price that an angel investor will pay in the Series A round of financing. The cap is designed to protect investors by limiting the amount they have to pay to convert their debt to preferred stock in the event that the company receives an unexpectedly high valuation in the Series A round. If, for example, the cap is $2 million and the pre-money valuation in the Series A round is $4 million, the amount of the note (plus accrued interest) would convert into shares of preferred stock based on a valuation of $2 million as opposed to $4 million.  We will also discuss certain investment instruments and forms of contract that are commonly used in Silicon Valley, which you should try to avoid.

While convertible debt is commonly used and has many important advantages, equity financing at the seed stage is also viable. The best course of action depends on your company and business plan.

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