Convertible Debt

Convertible debt is a type of investment a company can use to raise capital. Investments fall into two broad categories: debt and equity. When an investor takes equity for its investment, it becomes and equity holder (shareholder or membership interest holder) and is given the ability to elect directors and vote on important company decisions. By taking equity, the investor has no guaranty that their investment will produce a return and the investor rides along with the company through its growth and setbacks. When an investor takes debt for its investment, the investor does not participate in the equity of the company and, gains no control over company decisions. The terms of the debt, typically described in a promissory note or other debt instrument, entitle the investor to a specific repayment schedule and rate of return, described as an interest rate. By taking debt, the investor has much more certainty that their investment will be returned, and can even secure the debt with a security interest in the company’s property to hedge against the risk of the company’s inability to make required payments. Convertible debt is a hybrid between debt and equity. A convertible debt instrument works like regular debt in that there is a repayment plan and an interest rate; however, upon the occurrence of certain events (such as a major investment round or sale of the company), the outstanding principal and interest under the instrument converts into equity of the company at rate determined in the instrument. A major benefit of a convertible debt instrument for the company is that, initially, the company does not have to worry about obtaining investor approval for company decisions (as the investor is not an equity holder of the company prior to conversion). A major benefit for the investor is that the upside for the investor is greatly increased (the investor becomes an equity holder if the company experiences success and can even come into the equity at a discount relative to new investors, depending on the conversion terms in the convertible note).