Convertible debt is a loan that can be converted to equity. The borrower issues a convertible promissory note to the investor for a limited term, usually one or two years. When the note matures, the investor may cash in the note with interest, or he can convert the note into capital stock of the borrower's company. It is important to examine both the advantages and disadvantages of convertible debt.
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Easy For startup businesses to acquire
If you're starting a brand new business and having a hard time finding a bank to finance your venture, convertible debt may be an option. Convertible debt financing is cost effective and eliminates much of the legal complexity of traditional equity financing. It is often easier for start-up companies to find a lender willing to perform convertible debt financing, because the lender has less to risk.
Money without a valuation
Convertible debt allows a new business to get necessary investment funds without setting a valuation on the company before institutional investors enter the picture. Because new business owners tend to overvalue how much the business is worth, convertible debt gets rid of the risk of a down round, which is an investment round where a share price is lower than in the previous round. This is convenient if your family and friends are helping finance your new business, because they would likely be discouraged by institutional investment offers that are much lower than what you anticipated.
In a convertible debt agreement, investors are viewed as creditors of the start-up business. This is advantageous if the company liquidates or goes bankrupt. Note holders are shown preferential treatment when the company's assets are divided. As the note is secured against the borrower's assets, an investor may feel more secure lending using convertible debt than he would through a traditional bank loan.
Disadvantages for borrower
In the event that the convertible promissory comes due and it is not converted to equity or stock, the note still remains payable when the lender calls it in. The note is taken out against the company's assets, and the lender has the right to liquidate the assets to get his money. This can put a company in dire financial straits.
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- TroyGould Attorneys: Bridging the (Working Capital) Gap: An Annotated Convertible Promissory Note Term Sheet; Louis R. Dienes and Ekong I. Udoekwere
- Start-up Company Lawyer: Should a start-up company raise its seed round using a convertible note or Series A Preferred Stock?
- Entrepreneur Magazine: Raising Money Using Convertible Debt