An increasing trend since about 2010, in the Venture Capital world, is convertible debt. The thing is, convertible debt has become so defuse that it is no longer a fad but a reality that is here to stay. Here at MicroVentures we get questions from investors every day that relate to convertible debt, how it works, and why we (and everyone else) is using it.

What is Convertible Debt?

Entrepreneurs today have two options when it comes to raising money to fund their company, debt or equity. Debt is a loan which they must pay back within an agreed upon amount of time, with interest. Equity, instead, means they are providing a portion of ownership of their company in exchange for the investment.

Convertible debt, issued through a convertible note, is advantageous to founders because it allows the founder to A) delay giving up a portion of his/her company and B) delay setting a valuation for the company. A convertible note (referred to as a “note” in the Venture Capital world) is a hybrid funding solution. Notes are short-term loans which convert to equity at an agreed upon milestone or maturity date—usually a Series A round led by a VC firm. Since the investor is agreeing to these more “favorable” and “founder-friendly” terms, they usually get compensated for their loan/risk by getting discounts to what future investors will pay for equity.

Let’s walk through an example:

Terms of the note:

• $200,000 investment
• 20% discount
• $1,000,000 cap

Let’s say an angel investor invests $200,000 in a startup’s Seed Round as a convertible note. And the terms of the note include: a 20% discount in price (aka a “discount”) in future investment rounds. Let’s assume the next round of shares are priced at $1.00. When the next investment financing occurs, our debt investor can use his/her 20% discount. The investor can use that $200,000 debt investment to convert their shares at the discounted rate of $.80 each, instead of the $1.00 price that other (new) participants in the current funding round will have to pay. Having converted the note, the debt is no longer outstanding while that initial investor receives 250,000 shares for the price of $200,000; a 25% return — not bad.

Another feature which is common to convertible notes is called a cap. A cap is a maximum valuation on the company wherein the investor agrees to convert his/her shares—from debt to equity. Caps are used to protect early investors in case the value of the company skyrockets in the next financing round, the investor will get to convert their investment at the cap rate. Caps can get a little confusing. An easy way to remember the key mechanics is as follows: Investors want to buy in as cheaply as they can. The lower the cap the better the deal an investor gets. The higher the cap, the worse the deal.

So in the example above, if the investor and the company agree on a $1M cap, and the institutional investors who come in on the deal much later decide to value the company at $2M, then the investor converts his/her shares at the pre-agreed upon $1M valuation rate and see’s an immediate increase in their return.

Now let’s compare Convertible Debt to Equity:

While a convertible note might be a little confusing to calculate, equity is a breeze. The startup is assigned a pre-money valuation and a share price is determined. When you invest, you know exactly what the terms are and how many shares you will own in that round.

Here’s how Equity works:

• The startup has a pre-money valuation of $1,000,000 with 1,000,000 shares outstanding. This puts the share price at $1 per share.
• An angel investor makes an investment of $200,000 and receives 200,000 shares.
• The post-money valuation is $1,200,000 and the new investor owns 16.6% of the company.