You have a great idea. The business plans are set. You have a plan and are ready to put it into action. Just one ingredient is missing: money. As a brand new startup, you don’t yet have a pool of funds from which to pull. What’s more, you also haven’t yet established credit. So where do you get your funds? You may need to consider a convertible debt arrangement.
A convertible debt arrangement is essentially a loan from an angel investor. These angel investors are generally individuals with a lot of resources. Unlike banks and other institutions, they are more comfortable taking risks on new entities because they might see a bigger payout down the line. So they issue you a loan in the form of a convertible debt arrangement which can then be converted into equity as the business grows. Convertible debt arrangements are also slightly different from traditional loans because they have features such as early investor discounts which reward those who lend earlier more than those who lend later.+
Issuing investors convertible debt can have many advantages. For example, one of the most obvious advantages is that it eliminates the need to try and place a value on your company. Predicting what your company is worth, or will be worth, before it has even started can be complicated and often random. By offering debt, rather than stock, you aren’t predicting a value which later may or may not be accurate. Further, by issuing debt rather than stock, you are keeping yourself securely in the position of primary stockholder. You retain the right to make decisions regarding your new venture.
On the other hand, stock doesn’t come with the strings that may accompany debt. As convertible debt is essentially a loan, until it is converted to future equity, it may have the usual trappings of a loan. This could mean things such as interest payments. Additionally, while issuing debt maintains your role as majority shareholder now, it is possible, depending on the investments, that when the debt is later converted to equity, a single large investor could suddenly gain majority shareholder status.
So, should you use convertible debt? And if so, when should you consider it? First, examine all of your funding options. If there is another option available to you, that may be your best solution. However, in certain situations, convertible debt can offer a great solution. For example, if you have a business plan and know that you are within reach of accomplishing a big goal which will generate the money you need to move onto the next level, convertible debt can help bridge that gap.