- Another form of financing in a venture capital deal, separate from equity, is the idea of raising convertible debt. Now, convertible debt is really a proxy for equity. So, when you hear investors, or entrepreneurs, talk about raising a convertible debt round, what they're doing is, they're doing a financing and raising money today that, they have a full expectation that, in the future, it'll convert into equity, hence the phrase convertible debt. But, until it converts into equity, it is, in fact, debt, and it's debt that the company has a responsibility to pay back at some point or, based on some things in the future, will convert into equity.
Now, the reason some financings are done by convertible debt versus equity is, at the early stages, it's often perceived as easier, especially with smaller rounds or smaller dollar amounts, to simply raise on a convertible note and have that, when you have a larger financing, convert into equity. In some cases, entrepreneurs view the use of convertible debt as an advantage because you're deferring the pricing of the financing until some point later in time.
And from an optimistic perspective, theoretically, you'll get a better price at some point future in time. Interestingly, much of convertible debt financings today have started to look like a proxy, really, for true equity financing and have introduced terms like a convertible debt cap, or the price at which is the cap that the convertible debt converts into equity at. And that's really akin to what your maximum pre-money valuation is that you're going to get for that financing. Another thing that you'll often see in convertible notes today is an exit premium.
So, if the company gets sold, you get your debt paid back with interest, or you get some multiple on your money, or it converts into an earlier round of financing at whatever that price for that round of financing is. So, the investor gets whatever is the most to the investor of those scenarios. A long time ago, nobody did convertible debt except in difficult situations, where companies needed to extend their runway. And that was a way to extend your runway often until you had a new investor or a new round of equity.
In, about a decade ago, convertible debt became a very popular proxy for early-stage rounds because it was just easier and less expensive to do a very simple convertible debt financing. Today, the difference between doing that convertible debt financing and equity financing isn't that significant, and most venture lawyers will do early-stage equity financings for very little money. And the process, in a lot of ways, gets much more alignment between the investor and the entrepreneurs because you've decided on a price, you all own the same security, and you have the same motivation going forward to maximize the value of that equity.
So, recognizing that convertible debt is another type of tool that you can use to raise money against, it's important to recognize that the distinction, fundamentally, from equity today is not that significant. And in some cases, understanding the downside of having convertible debt versus just simply raising equity is really important.
- Exploring potential stakeholders: friends, family, and more
- Finding a venture capital firm
- Breaking down the term sheet
- Taking on debt
- Asking for NDAs
- Accepting a no