What is Convertible Debt?
Convertible loans or convertible notes are other names of convertible debt. To be exact it is a debt in which a company borrows money from an investor or a group of investors with an objective that both the investors and the company change the debt to equity at a later stage. Usually how debt will be converted into equity is mentioned at the time when the loan is requested. At times compensation is also offered in the form of a discount or a warrant.
Reasons for using Convertible Debt
There are many reasons why the investors and the company prefer to issue debt rather than equity and later convert it into equity. The reason for any company is clear as it believes that at a later date its equity will be of more worth. Secondly, the transaction cost, which mainly is legal fees, is generally less when debt vs. equity is issued.
As for the investors, the preference for debt vs. equity is not very clear. At times investors are more excited to get the opportunity to make an investment in a company that they place their money into a convertible note and wait for let the next round investors to set the price.
They don’t insist on setting a price at that time as they believe that the company wouldn’t take their money. Other times investors believe that the compensation, in the form of a discount or a warrant is important because it counterbalance the worth of taking debt vs. equity.
Warrants or discounts
Characteristically there are two forms of compensation for making a convertible loan; warrants or a discount.
This is another type of an option or in other words similar to options. The Warrant will be an option for any security that is sold in the next round. In the typical convertible note it is usually expressed in terms of “warrant coverage percentage”.
Points to consider using convertible debt
Below are the points and decisions which should be considered while using convertible debt.
- What triggers the conversion? Select to mention an event or set of events for example, revenue or a financing threshold or any other business landmark. Mostly investors and entrepreneurs concur to set the communication to take place at a financing event.
- Any discount upon conversion? A tricky decision to offer discount to early investors. But a no discount or a too low one might not get investors to commit before the next round. At the same time if the discount is too high the next round’s investor will reason it in the discount when stocks are being priced.