From The Archives: Convertible Debt

I wrote this in July 2011, as a part of an MBA Mondays series on financing structures:


MBA Mondays are back after a one week hiatus. Today we are going to talk about convertible debt. Convertible debt can also be called convertible loans or convertible notes. For the purposes of this post, these three terms will be interchangeable.

Convertible debt is when a company borrows money from an investor or a group of investors and the intention of both the investors and the company is to convert the debt to equity at some later date. Typically the way the debt will be converted into equity is specified at the time the loan is made. Sometimes there is compensation in the form of a discount or a warrant. Other times there is not. Sometimes there is a cap on the valuation at which the debt will convert. Other times there is not.

There are a number of reasons why the investors and/or the company would prefer to issue debt instead of equity and convert the debt to equity at a later date. For the company, the reasons are clearer. If the company believes its equity will be worth more at a later date, then it will dilute less by issuing debt and converting it later. It is also true that the transaction costs, mostly legal fees, are usually less when issuing debt vs equity.

For investors, the preference for debt vs equity is less clear. Sometimes investors are so eager to get the opportunity to invest in a company that they will put their money into a convertible note and let the next round investors set the price. They believe that if they insisted on setting a price now, the company would simply not take their money. Sometimes investors believe that the compensation, in the form of a warrant or a discount, is sufficiently valuable that it offsets the value of taking debt vs equity. Finally, debt is senior to equity in a liquidation so there is some additional security in taking a debt position in a company vs an equity position. For early stage startups, however, this is not particularly valuable. If a startup fails, there is often little or no liquidation value.

Friends and family rounds, which we discussed earlier in this series, are often done via convertible debt. It makes sense that friends and family would not want to enter into a hardball negotiation with a founder and would prefer to let the price discussion happen when professional investors enter the equation.

The typical forms of compensation for making a convertible loan are warrants or a discount.

Warrants are another form of an option. They are very similar to options. In the typical convertible note, the Warrant will be an option for whatever security is sold in the next round. The Warrant is most often expressed in terms of “warrant coverage percentage.” For example “20% warrant coverage” means you take the size of the convertible note, say $1mm, multiply it by 20%, which gets you to $200,000, and the Warrant will be for $200,000 of additional securities in the next round. Just to complete this example, let’s say the next round is for $4mm. Then the total size of the next round will be $5.2mm ($4mm of new money plus $1mm of the convertible note plus a Warrant for another $200k). The total cost of the convertible loan is $1.2mm of dilution at the next round price for $1mm of cash.

A discount is simpler to understand but often more complicated to execute. A discount will also be expressed in terms of a percentage. The most common discounts are 20% and 25%. The discount is the amount of reduction in price the convertible loan holders will get when they convert in the next round. Let’s use the same example as before and use a 20% discount. The company raised $4mm of new cash and the convertible loan holders will get $1.25mm of equity in the round for converting their $1mm loan ($1mm divided by .8 equals $1.25mm). Said another way $1mm is a 20% discount to $1.25mm.

Convertible notes also typically have some cap on the valuation they can convert at. That cap is anywhere from the current valuation (not very common) to a multiple of the current valuation. Recently we are starting to see uncapped convertible notes. These notes have no cap on the valuation they can convert at.

Startups typically think about raising capital via convertible debt early on in the life of a startup. They want to move fast, keep transaction costs low, and they are often dealing with a syndicate of angel investors and it is easier to get the round done with a convertible note than a seed or series A round. While these are all good reasons to consider convertible debt, I am not a big fan of it at this stage in a company’s life. I believe it is good practice to set the value of the equity early on and start the process of increasing it round after round after round. I also do not like to purchase or own convertible debt myself. I want to know how much of a company I’ve purchased and I do not like taking equity risk and getting debt returns.

However, later on in a company’s life convertible debt can make a lot of sense. A few years ago, we had a portfolio company that was planning on an exit in a year to two years and needed one last round of financing to get there. They went out and talked to VCs and figured out how much dilution they would take for a $7mm to $10mm raise. Then they went to Silicon Valley Bank and talked to the venture debt group. In the end, they raised something like $7.5mm of venture debt, issued SVB some Warrants as compensation for making the loan, and built the company for another year, sold it and did much better in the end because they avoided the dilution of the last round. This is an example of where convertible debt is really useful in the financing plan of a startup.

My guess is we will see the use of convertible debt, particularly with no compensation and no cap on valuation, wane as the current financing gold rush fizzles out. It will remain an important but less common form of early stage startup financing and will be particularly valuable in things like friends and family rounds where all parties want to defer the price negotiation. But I expect that we will see it used more commonly as companies grow and develop more sophisticated financing needs. It is a good structure when the compensation for making the loan is fair and balanced and when the debt vs equity tradeoff is useful for both the borrower and lender.

#MBA Mondays

Comments (Archived):

  1. JimHirshfield

    {Insert archived witty comment here; circa July 2011}

    1. William Mougayar

      But you weren’t that witty then ;)You were still with Disqus, no? Ouch

      1. JimHirshfield

        Nope. That was a year before I joined Disqus.

    2. Girish Mehta

      Like somebody said…”There is only one thing worse than mailing it in, and that is not mailing it in”.(With due apologies to Oscar Wilde).p.s. Jokes apart, Mailing it in is a privilege, and pretty sure Fred has earned that privilege insofar as this blog is concerned.

      1. JimHirshfield

        Admit it: you can’t live, wit or wit out my comments.

        1. Girish Mehta

          A mailed-in imaginary comment in response to a mailed-in post, besides being very witty, has the added benefit of not saying anything. https://uploads.disquscdn.c

      2. fredwilson

        I did mail it in but strategically so. The convo we started here yesterday is still going on out in the social web and so I thought it made sense to add something to it

        1. Girish Mehta

          Yes..saw the tweets debate redux earlier today on my TL.Don’t know if this is a either/or question where one approach would be better in all situations.

  2. Jean Jacques

    Hi Fred, I really enjoyed this post.We have two investor prospects that want to invest in our seed round of financing.We have a high growth fintech startup, and we are raising our first round of outside capital.I have bootstrapped the company since last year. Should I consider doing a priced round at a $5M post for the two investments of $250,000 each ($500,000 total) or use a SAFE/convertible note for the $500,000.We will raise another $3.5M to $4.0M in 6-9 months to fill out the full engineering, design, and exec teams.

    1. fredwilson

      I would price the round

    2. Jean Jacques

      Thanks Fred.

  3. Antone Johnson

    In the grand old tradition of mailing it in, as useful as Fred’s original post on convertible debt remains to this day, so does his impromptu Twitter exchange on the subject a year later with Dave McClure, Mark Suster, Chris Dixon, Adam Nash, Scott Belsky, Ted Rheingold, Jonathan George, Marcus Ogawa and more. It was a remarkable meeting of sharp minds that flourished spontaneously one Saturday morning, classic Twitter at its best. I Storified it here:…The conversation hasn’t changed much since Sep. 2012, except (1) SAFEs have eclipsed “convertible equity” (Adeo Ressi’s contribution) as the most common convertible note variant, and (2) with a couple more years experience seeing startups pile up and [re-]extend convertible debt seed rounds, the consequences Fred highlights in his previous post are becoming increasingly clear.

    1. fredwilson


  4. creative group

    CONTRIBUTORS:The MBA without the price. Just invest your time……

    1. karen_e

      So true.

  5. Mike Zamansky

    This post really brings me back – in another life I did tech work in support of trading Japanese warrants back at Goldman.

  6. LE

    Silicon Valley Bank and talked to the venture debt group. In the end, they raised something like $7.5mm of venture debt, issued SVB some Warrants as compensation for making the loanWho is the NYC or east coast equivalent of SVB that does a similar thing with venture debt for startups? Is there a market typically for these warrants and are they bought and sold by the issuing bank?

  7. Lydia Fayal

    It would be really cool if a few founders could weigh in on the debt vs. priced round debate. Perhaps from some of the companies you invested in?This debate always feels like New York vs. Silicon Valley. When NYC based investors talk about their preference for priced rounds, they write about investor pains and want to solve for the problems that come up when a company valued at $25M+ needs to raise capital. Meanwhile, advocates of convertible notes / SAFE docs write about founder frustrations… That’s part of the appeal to founders. Even if founders don’t fully understand the nuances of debt, they (we) are more likely to trust successful founders. We feel like they understand the potential pitfalls.A few thoughts as a founder:-When this post was originally written, companies might raise $2M for their Series A. Now a Series A usually entails raising $5-10M. To do this, you need a much higher valuation… so the company needs to be further along.-Convertible notes provide more flexibility. You don’t want to take more money than necessary at a low valuation (this is why Chalkup is doing notes).-It’s easier to get small strategic investors such as other founders to invest in your company via convertible notes. They don’t want to deal with legal fees and negotiations.-Very few VC firms invest under $2M – even those with smaller seed funds, usually use those funds for their repeat founders. This makes angel investors much more appealing… but they don’t necessarily have the experience to price a round, and founders rarely have that experience.-Most of the problems angel investors have with convertible notes can be solved via a valuation cap.-In a priced round, getting everyone to close at the same time is often a nightmare. This leads founders to prefer firms that can move quickly and/or agree to do the entire round… but they might not be the best long term investors.BUT there are plenty of issues with convertible debt. I hope a new form of financing is established when this “gold rush fizzles out” … I’d love to get your thoughts on alternative (perhaps untested?) methods of raising capital. 🙂

  8. jason wright

    Posts were longer back then.

  9. James Barlia

    Thank you for the insight – I am currently taking a VC/PE class and we discuss convertible debt frequently. I also interned at a VC firm this past summer who used convertible debt frequently. I understand convertible debt is frequent among early stage capital raises, however, what is the impetus behind Tesla using convertible debt to raise $1B this week? Is it more or less beneficial for a public company? James Barlia, May 2018. Freeman School of Business, Tulane University.