Convertible Debt: Key Features, Benefits & Risks

Raising capital is one of the most critical challenges for startups and growing companies. Convertible debt offers a unique approach to funding that balances flexibility with opportunity.

In this article, we’ll explore everything you need to know about convertible debt — from how they work to their key features, benefits, and potential risks. 

Whether you’re an entrepreneur, investor, or finance professional, this guide will help you better understand this versatile financing tool and how to make it work for your goals.

What is Convertible Debt?

Convertible debt (also referred to as a convertible note) is a hybrid financing instrument that combines the features of traditional debt and equity.

It begins as a loan or promissory note, where the company receives capital from investors with a promise to repay the principal amount, often with accrued interest. However, instead of repayment in cash, the debt can convert into equity shares of the company at a future date, triggered by specific conditions or milestones, such as a new funding round or a pre-defined timeline.

This dual nature makes convertible debt a flexible and attractive option for both startups and investors. Its popularity extends beyond private markets. In Q1 2024 alone, more than $20 billion was issued in the convertible debt sector in the US and $26 billion globally, showcasing the enduring appeal of convertible instruments.

Convertible debt is commonly used by early-stage companies seeking quick access to capital while deferring detailed valuation discussions until a later funding round.

Its adaptability, simplicity, and balance of risk and reward have made it a cornerstone in startup financing and venture capital.

Why Companies Use Convertible Debt

Convertible debt offers strategic benefits for companies, particularly in the early stages of growth. Some of the main reasons companies choose this financing method include:

• Avoid Immediate Dilution: Convertible debt allows startups to raise funds without immediately diluting the ownership of existing shareholders. The conversion to equity happens later, typically during a larger funding round. 
• Simpler Negotiations: Since there’s no need to determine the company’s valuation upfront, discussions with investors can focus on terms like interest rates, maturity dates, and conversion mechanisms, streamlining the fundraising process.
• Flexibility for Growth: By deferring the equity conversion, companies can use convertible debt to bridge gaps between funding rounds or accelerate growth while planning for future valuation milestones.

After years of working with venture firms and investing in early-stage startups, I’ve observed that convertible debt offers a way to secure funding without immediately assigning a valuation to the business, which can be especially helpful in early stages when the company’s worth is difficult to determine.

While convertible debt offers these strategic advantages to companies, it also provides distinct benefits to investors, making it a mutually appealing option.

Why Convertible Debt is Attractive to Investors

Convertible debt is an appealing choice for investors because it balances potential rewards with reduced risk. Key reasons include:

• Potential Upside: Investors benefit from the opportunity to acquire equity in a company at a lower price than future investors, especially if the company’s valuation grows significantly.
• Interest Income: While waiting for conversion, investors typically earn interest on their investment, adding a steady return during the interim period.
• Priority While Unconverted: Convertible debt holders are repaid before equity shareholders if the company is liquidated while the debt remains unconverted. This provides a level of security not available with direct equity investments.
• Post-Conversion Status: Once the debt converts into equity, the holder’s rights align with the specific class of stock issued, including any applicable liquidation preferences.

The flexibility and advantages of convertible debt make it a popular choice in a variety of financing scenarios, including these common use cases. Having deployed over $300 million in invested capital in high-growth companies, I can attest that convertible debt provides an opportunity to gain equity in a promising startup or growing business, often at a discounted rate or with additional protections like valuation caps.

Common Use Cases for Convertible Debt

The practical applications of convertible debt highlight its versatility as a financing tool. Here are some common scenarios where companies and investors leverage its benefits:

• Seed Funding for Startups

Convertible debt is a popular tool for early-stage companies to secure initial capital while postponing valuation discussions until they achieve significant growth milestones.

As Bond Collective explains, “Convertible debt typically comes before your startup’s first round of stock offering (the series A funding round), [and] investors aptly refer to it as a seed investment.” This strategic approach allows startups to access funding quickly and efficiently, avoiding the complexities of immediate equity negotiations and focusing instead on growth and scalability.

• Bridge Financing

Companies often face funding gaps between rounds or need short-term capital to finance critical projects. Convertible debt serves as an effective bridge in these situations, providing the necessary funds while deferring equity discussions.

This flexibility allows startups to maintain momentum, whether it’s hiring key personnel, launching new products, or meeting operational milestones. With my background in venture capital and angel investing, I’ve seen firsthand how convertible debt can enable companies to achieve growth milestones and position themselves for a larger equity raise.

• Incentivizing Early Investors

Convertible debt is designed to reward early supporters who take on higher risks by offering favorable terms like valuation caps and discounts.

These mechanisms ensure that early investors receive equity at a lower valuation than later participants, compensating them for their trust and commitment. This not only attracts initial funding but also builds confidence among subsequent investors, setting the stage for successful future rounds.

With my background in venture capital and angel investing, I’ve seen firsthand how convertible debt can be a bridge between funding rounds, providing the capital needed to achieve growth milestones or secure key hires while preparing for a larger equity raise.

Key Features of Convertible Debt

Convertible debts come with several defining features that make them a popular choice for startups and investors. These features not only establish the structure of the financing but also determine how and when the notes transition from debt to equity.

Understanding these characteristics is crucial for maximizing the benefits of convertible debt.

Interest Rates and Maturity

One of the core features of convertible debt is the interest rate, which compensates investors for the risk they take by providing early-stage funding.  The convertible debt interest rate can range from 2% to 8%. However, it stays most often in the 5% to 6% depending on the agreement and market conditions.

This interest is often rolled into the principal and converted into equity alongside the original loan amount, increasing the investor’s stake in the company.

• For example, an investor with a $100,000 convertible debt at a 5% annual interest rate would see their principal grow to $105,000 after one year. If the note converts to equity at this point, the investor would receive shares equivalent to the total $105,000.

The maturity date sets a deadline for the convertible debt.

By this date, the company must either repay the note in full or convert it into equity, depending on the terms. However, maturity dates are often flexible. Investors may agree to extend the deadline, especially if the company is close to achieving a conversion event, such as a major financing round.

This flexibility helps startups manage their cash flow and timeline while maintaining investor confidence.

Conversion Triggers and Events

Conversion triggers determine the circumstances under which the debt transitions into equity. These triggers are typically tied to significant milestones, such as:

• Qualified Financing Rounds: A new round of investment, usually led by a major investor, often serves as a trigger. For example, if a lead investor contributes $1.5 million at a pre-money valuation of $10 million, it may activate the conversion of outstanding convertible debts into equity.
• Corporate Events: Major events like an initial public offering (IPO) or acquisition may also trigger conversion. In such cases, the notes convert into equity based on pre-agreed terms, allowing investors to participate in the company’s growth or exit.

Here’s a practical example that highlights how these triggers operate.

• Suppose an investor holds a $100,000 note with a 5% interest rate. If a qualified financing round occurs after one year, the total $105,000 (including accrued interest) is converted into shares at a pre-agreed price per share. This conversion gives the investor equity in the company, aligning their interests with its long-term success.

In addition to interest rates, maturity, and conversion triggers, convertible debts often include terms like valuation caps and discount rates (discussed in detail below).

These terms provide further clarity on how conversion terms are calculated and ensure early investors receive favorable terms when the debt transitions to equity.

Learn more about Pre-Money vs Post-Money Valuation.

Valuation Caps and Discount Rates

Valuation caps and discount rates are key mechanisms in convertible debt agreements that reward early investors for the risks they take by offering more favorable conversion terms.

These features not only incentivize early investment but also protect investors from being significantly diluted in future funding rounds. This is especially so during a lower valuation round, where new equity is issued at a reduced company valuation.

A valuation cap sets a maximum company valuation at which the convertible debt can convert into equity. This cap ensures that early investors benefit from their initial risk by allowing them to convert their debt at a favorable price, even if the company’s valuation significantly increases in later funding rounds.

Example:

An investor holds a convertible debt with a $10 million valuation cap.

• If the company raises a Series A round with a pre-money valuation of $15 million and the price per share is calculated as $1.50, the investor’s note will convert at the capped valuation instead.
• This means the note holder’s conversion price would be $1.00 per share, giving them more shares for the same investment compared to investors in the Series A round.

Valuation caps align early investors’ interests with the company’s growth, ensuring they share in the upside of future success.

A discount rate offers another way to reward early investors by allowing them to convert their debt into equity at a reduced price compared to new investors. This mechanism compensates early investors for the higher risk taken by those who invest earlier in a company’s lifecycle.

Example:

An investor holds a convertible debt with a 20% discount rate.

• If the Series A price per share is $10, the note converts at $8 per share, reflecting the 20% discount.

While valuation caps and discount rates are commonly used in convertible debt agreements, not all agreements include both mechanisms. Some agreements may feature only one, depending on the terms negotiated between the company and investors.

In cases where both mechanisms are included, the convertible debt typically converts at the more favorable of the two terms.

Example:

If a note has a $10 million valuation cap and a 20% discount rate, and the Series A valuation results in a share price of $12:

• Using the valuation cap, the conversion price would be $1.00 per share.
• Using the discount rate, the conversion price would be $9.60 per share (20% off $12).
• The note would convert at $1.00 per share because the valuation cap is more favorable.

Valuation caps and discount rates are essential features that help balance risk and reward in convertible debts:

• For Investors: They provide protections and incentives for supporting a company during its riskiest phase.
• For Companies: They make convertible debts more appealing to early backers without committing to an immediate valuation, simplifying the fundraising process.

Together, these mechanisms ensure that convertible debts remain an attractive and flexible option for both startups and investors, fostering growth and innovation.

Default and Repayment Terms

Convertible debt includes specific repayment terms that outline the obligations of both the company and the investor if conversion does not occur by the maturity date.

These terms are critical for setting expectations and minimizing disputes.

If no conversion event occurs by the maturity date, the company usually must repay the principal amount of the debt plus any accrued interest.

However, repayment terms can vary based on the agreement.

Some convertible debt agreements allow investors to extend the maturity date, giving the company more time to achieve a conversion event. This flexibility is often negotiated during the initial agreement.

A default occurs when the company fails to meet its obligations under the convertible debt agreement. Common events of default include:

• Non-payment: Failure to pay interest or repay the principal by the maturity date.
• Insolvency: If the company declares bankruptcy or becomes unable to pay its debts.
• Breach of Terms: Not meeting specific conditions outlined in the agreement, such as failure to achieve milestones or improper use of funds.

In the event of a default, investors may have several options depending on the terms of the agreement and applicable laws. These include:

• Demand immediate repayment of the outstanding debt.
• Convert the debt into equity on less favorable terms to the company.
• Seek legal remedies, depending on the jurisdiction and agreement terms.

When structuring convertible debt, it is essential for both companies and investors to address potential pitfalls to avoid financial and legal complications:

1. Insufficient Documentation

Poorly drafted agreements can lead to disputes over repayment terms or conversion conditions.

Companies should ensure that all key terms – such as interest rates, maturity dates, and default conditions – are clearly and explicitly outlined in the debt agreement.

2. Tax Implications

While conversion events are generally non-taxable, any accrued interest that has not been reported as income may become taxable upon conversion.

Companies and investors should consult tax advisors to fully understand their obligations and avoid unexpected liabilities.

3. Misstructured Agreements

Improperly designed debt agreements may inadvertently create unfavorable conditions, such as excessive dilution for the company or inadequate protections for investors. 

This can lead to financial mismanagement or strained relationships.

4. Default Consequences

If default terms are overly punitive or unclear, they can create significant financial strain for the company or fail to provide adequate recourse for investors. Structuring fair and balanced default terms is crucial.

Benefits for Companies and Investors

Convertible debt is a versatile financing option that offers significant advantages for both startups and investors.

Benefits for Companies

• Flexible Financing: Convertible debt allows startups to raise capital without the immediate need to establish a valuation, which can be particularly challenging in the early stages when the company’s worth is uncertain. This flexibility allows companies time to grow and achieve milestones before a formal valuation.
• Minimized Dilution: Since the debt converts into equity at a later stage, existing shareholders avoid immediate dilution of their ownership. This is especially important for founders and early team members who want to retain control during the company’s formative years.
• Streamlined Fundraising: Convertible debt simplifies negotiations by focusing on terms like interest rates, maturity dates, and conversion triggers instead of debating the company’s valuation. This can speed up the fundraising process and make it more efficient.
• Bridge to Larger Rounds: Startups can use convertible debt as a bridge between funding rounds, providing the capital needed to achieve growth milestones or secure key hires while preparing for a larger equity raise.

Benefits for Investors

• Lower Risk: Compared to common equity, convertible debt typically has a higher priority in the event of liquidation. This means that investors are more likely to recover their investment if the company fails.
• Potential Upside: Investors benefit from the opportunity to convert their debt into equity at favorable terms, especially if the company achieves significant growth. Features like valuation caps and discounts reward early participation by ensuring investors receive a more advantageous conversion rate.
• Interest Payments: Convertible debt often accrues interest, providing a modest return before conversion. This feature adds an additional layer of security and attractiveness for investors, offering both immediate and long-term benefits.
• Equity-Like Returns with Debt Protections: Investors enjoy the potential upside of equity ownership while retaining the protections and repayment priority associated with debt instruments, creating a balanced risk-reward profile.

The dual benefits of convertible debt make it a valuable financing option for companies seeking capital and investors looking for favorable opportunities.

Negotiating Convertible Promissory Notes

Negotiating convertible debt requires careful attention to detail and alignment between the company and its investors. A successful negotiation establishes terms that balance the needs of both parties while ensuring transparency and flexibility.

One of the most important tools in this process is the term sheet.

This critical document serves as a non-binding agreement that outlines the basic terms and conditions of the convertible debt. Acting as a blueprint, it ensures that both the company and the investors are on the same page before drafting the final agreement.

Key terms to negotiate include:

• Maturity Date: The maturity date specifies when the debt must be repaid or converted into equity. Both parties should agree on a timeline that aligns with the company’s expected milestones and financial projections. Flexibility in extending the maturity date can also be negotiated to account for unforeseen delays.
• Interest Rate: The interest rate determines the return investors will receive before conversion. Negotiating a fair rate ensures the investment remains attractive to investors while being manageable for the company. Typical rates range from 5% to 6%, but this can vary depending on the risk profile of the company.
• Conversion Terms: Conversion details, including triggers, valuation caps, and discounts, are among the most crucial elements to negotiate. These terms dictate how and when the debt converts into equity and at what price. Clearly defined terms reduce the likelihood of disputes and ensure smooth transitions during future funding rounds. Investors may also negotiate additional protections, such as a right of first refusal on future equity sales, allowing them to maintain their ownership percentage if the company raises new capital.
• Default and Repayment Conditions: It’s important to outline the consequences of default, including repayment obligations and the rights of investors in such scenarios. Establishing balanced terms protects both the company and the investors.

As a lecturer at Wharton MBA program on product management and a seasoned investor, I understand that convertible debt simplifies negotiations by focusing on terms like interest rates, maturity dates, and conversion triggers instead of debating the company’s valuation.

Convertible debt agreements should also be tailored to fit the company’s specific goals and circumstances. 

Customizing terms, such as the use of valuation caps or deferred interest payments, allows the company to structure financing that supports its long-term strategy while remaining appealing to investors.

Engaging experienced legal counsel is strongly recommended during negotiations.

A lawyer can help:

• Draft and review the term sheet and final agreement.
• Ensure compliance with applicable laws and regulations.
• Mitigate potential risks for both parties.

Negotiating convertible debt is a collaborative process that requires clear communication, strategic thinking, and attention to detail. By addressing key terms upfront and ensuring alignment between all parties, companies and investors can create agreements that support mutual success.

Tax Implications of Convertible Debt

Convertible debt comes with unique tax considerations that both companies and investors need to understand. Properly managing these implications can prevent unexpected liabilities and ensure compliance with tax regulations.

Purchasing convertible debt is generally not a taxable event for investors, as no immediate income or gain is recognized unless property is exchanged in the transaction.

This makes it a straightforward and efficient option for raising capital.

When the debt converts into equity, the conversion itself is typically non-taxable. Tax law views this process as a change in ownership form rather than a sale or disposition, so investors do not incur taxes at the point of conversion.

However, there are important considerations and exceptions to keep in mind:

• Accrued Interest: If the convertible debt has accrued interest that has not yet been reported as income, this portion becomes taxable upon conversion. For example, if an investor holds a note with $5,000 of accrued interest that is added to the principal during conversion, this amount may be subject to taxation.
• Capital Gains: If the equity received from conversion is later sold, any capital gains or losses realized will be subject to capital gains tax.
• Special Transactions: Certain scenarios, such as the exchange of convertible debt for appreciated property or equity under specific conditions, may trigger additional tax consequences.
• Control Rights: If investors negotiate for control rights as part of the agreement, the IRS may classify the instrument as equity rather than debt, potentially altering its tax treatment.

Companies should also be mindful of their own tax reporting obligations.

Depending on the structure of the agreement and applicable laws, certain aspects of the convertible debt could impact the company’s financial statements and tax filings. To navigate these complexities, companies and investors are strongly advised to consult with tax professionals.

Advisors can provide guidance on:

• Reporting accrued interest appropriately.
• Ensuring compliance with federal, state, and local tax laws.
• Structuring agreements to minimize tax exposure for both parties.

Understanding the tax implications of convertible debt is essential for making informed financial decisions. With proper planning and professional advice, companies and investors can leverage convertible debt effectively while avoiding unexpected tax liabilities.

Frequently Asked Questions

What happens if the company cannot repay the convertible debt at maturity?

If the company cannot repay the debt at maturity and no conversion event has occurred, investors typically have the right to demand repayment, renegotiate terms, or, in some cases, convert the debt into equity at a less favorable rate. The exact course of action depends on the terms outlined in the agreement.

Is it possible to renegotiate convertible debt terms after issuance?

Yes, the terms of convertible debt can often be renegotiated if both parties agree. For example, investors may agree to extend the maturity date or modify conversion terms to support the company’s financial position.

Are there risks for investors with convertible debt?

Yes, while convertible debt offers protections like liquidation preference, risks remain. These include the possibility of the company failing before a conversion event, dilution if additional funding rounds occur, or disputes over unclear terms. Learn about anti-dilution.

Can convertible debt be issued by established companies or only startups?

While convertible debt is most commonly associated with startups, established companies can also use it to raise capital. For example, public companies may issue convertible bonds, a form of convertible debt, as part of their financing strategy.

How does convertible debt compare to a SAFE (Simple Agreement for Future Equity)?

Convertible debt is a loan with interest and a maturity date, providing repayment or equity conversion options under specific conditions. A SAFE, by contrast, is not debt—it lacks interest and repayment obligations, instead offering equity conversion based on future valuation triggers like funding rounds. Both are flexible funding tools, but convertible debt involves creditor protections, while SAFEs focus solely on equity agreements.

Conclusion

Convertible debt is a versatile and powerful financing tool that offers unique advantages to both companies and investors. Its flexibility allows startups to secure funding without immediate valuation concerns, while investors benefit from potential upside with added protections.

Understanding key features like interest rates, conversion terms, and tax implications enables stakeholders to make informed decisions and structure agreements that align with their goals.

With proper planning, clear documentation, and expert guidance, convertible debt can foster mutually beneficial partnerships that support growth and innovation.