Convertible debt can solve a very common problem for early stage startups: it allows founders to delay determining the value of their company and still take money from investors.
Let’s say you come up with an idea for a coffee-flavored lemonade stand. You don’t know if this will be a total flop or the next Starbucks, but you need $50 to get this lemonade stand launched.
You go to Uncle Earl. He’s willing to contribute $50, but since you can’t figure out what the value of the lemonade stand is—it’s not even launched yet!—he agrees to give the $50 now and figure out what percentage of the business he will get later.
Earl only agrees to do this because you offer him 3 financial incentives which make it interesting to him:
You give him 20% more than he invested (“Discount Rate”).
When you take your next round of investment, Earl will get his $50 contribution plus an additional 20% ($60 total) into that round.
You cap how much he’d ever have to pay on valuation (“Cap Rate”).
If the valuation of the company skyrockets on the next capital raise, Ol’ Earl will pay no more than a $500 valuation. So if the value jumps to $1,000, Earl still pays no more than $50 for 10% of the company.
You pay interest on the amount he invested (“Interest Rate”).
When his $50 debt is converted to equity, you’ll also pay him simple interest on the $50 for however long you’ve held onto it.
This is great. You get to use Earl’s $50 investment to launch, and don’t have to worry about converting it into equity until you take on another investment, or after two years have passed (typically). This is a quick and easy structure that allows you to focus on building your company now, and worry about equity valuations later. Woohoo!
Of course, it’s not quite this simple. (If only!) This is just the start of our five-part series on convertible debt – in the next installment we explore the benefits of this financing tool for founders. As always, you can chime in with your thoughts @startupsco.