Convertible Debt as a Fundraising Tool  

May 21, 2024

Alegalis -  In the growing context of start-ups and their forms of financing, one of the most widely used tools is convertible debt, which is a flexible and effective mechanism to leverage fundraising rounds. Essentially, convertible debt is debt that starts as a loan and is later capitalised and converted into equity. This mechanism has several advantages in the world of entrepreneurship, but it can also be a challenge for investors and entrepreneurs alike. 

In the vast majority of cases, the point at which convertible debt is converted into equity is at the time of future funding rounds of the same company or start-up. As with all debt, this mechanism involves an interest rate in favour of the investor and a discount at the time of the fundraising round. The way the discount works is as follows: If a company raises $100,000 in convertible debt at a 10% discount, at the time of a future capital raising round where the share price is set at $1, the convertible debt holder will be able to buy the shares for $0.90. That is very attractive to investors. 

This is very attractive to the initial investors because the company is expected to grow in value over time, so they will benefit not only from the interest rate but also from the difference in the share purchase price resulting from the discount. From the entrepreneur’s point of view, there are also advantages to be gained from the simplicity of this mechanism.

Issuing convertible debt avoids in-depth discussions about the current valuation of the company. It also reduces costs in terms of paperwork and legal fees. Therefore, in the short term, it is an attractive mechanism because it is easy to execute immediately. 

Where there are arguments against convertible debt is in the potential complications that its use may cause in the future. While the use of convertible debt avoids an in-depth discussion of the valuation of the company at the time of issuance, it makes such a discussion a highly complex issue at the time of a future fundraising round when the agreed markdowns take effect. This is particularly the case when setting valuation caps, and discounts can also act as a disincentive to new investors.

In light of the above, one of the main mechanisms that has emerged as an alternative to convertible debt is the so-called SAFE. They act as a call option for initial investors. The advantages are that they do not represent debt for the company itself and elements such as the existence of an interest rate are eliminated; however, they require more discussion of the current valuation of the company, which leads to higher costs. 

In conclusion, convertible debt and any other instrument that can be used to raise funds for an early stage company has different advantages and disadvantages. For this reason, it is of the utmost importance to have the necessary legal and financial advice to be able to carry out this type of operation efficiently, analysing which figure best suits the needs of the entrepreneur, the company and potential investors.  

Reference: Feld, B., & Mendelson, J. (2019). Venture Deals BE SMARTER THAN YOUR LAWYER AND VENTURE CAPITALIST (4th ed., Vols. 160-178). John Wiley & Sons, Inc.

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