📖 Business
Convertible Debt
Convertible debt is a loan that converts into equity at a future financing round rather than being repaid in cash. It's the most common instrument for seed-stage funding because it sidesteps the hardest problem in early-stage investing: setting a fair valuation when the company is too young to price. Instead of negotiating a valuation today, the investor lends money that will convert into shares at the next priced round's valuation — usually with sweeteners (a discount and/or a cap) that reward the early investor for taking more risk. The simplicity and lower legal costs make it attractive for both sides, but the mechanics can create surprising outcomes if founders don't model them carefully.
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How It Works
Core terms of a convertible note:
Discount (typically 10-30%):
- The note converts at a discount to the next round's price per share.
- If Series A prices at $10/share with a 20% discount, note holders convert at $8/share.
- This gives early investors more shares for the same investment — their reward for investing earlier.
Valuation cap:
- A maximum valuation at which the note converts, regardless of how high the next round prices.
- If the cap is $5M and Series A is at $20M pre-money, the note converts as if the valuation were $5M.
- Protects early investors from extreme dilution if the company's valuation skyrockets.
- When both a discount and a cap exist, the investor typically gets whichever produces more shares.
Interest rate (typically 4-8%):
- Accrues over the life of the note and converts into additional shares at conversion.
- On a $500K note at 6% for 18 months, ~$45K in interest also converts into equity.
- Often overlooked by founders but adds meaningful dilution over long periods.
Maturity date:
- When the loan comes due if no qualifying financing has triggered conversion.
- Typically 18-24 months. If maturity hits without conversion, the company technically owes the money back.
- In practice, this is usually extended or renegotiated — but it's leverage for the investor.
Why convertible debt exists:
- Avoids premature valuation negotiation
- Simpler legal docs (~$5-10K vs. $25-50K for a priced round)
- Faster to close (days vs. weeks)
- Allows rolling closes — investors can come in at different times on the same terms