The Benefits of Convertible Debt for Companies

You've likely encountered the terms 'convertible debt' or ‘convertible note’ when weighing alternative fundraising strategies, particularly in the early stages of your company's growth.

It's often highlighted as a popular means of quickly securing financial investment, with several benefits that make it a desirable option for startups. 

While our guide to convertible notes covers the legal considerations and structure of convertible debt, here we explore the key benefits and risks for companies.

We'll cover: 

• What is convertible debt?
• When is convertible debt most commonly used? 
• How does convertible debt financing compare to traditional equity financing? 
• Cost-effective financing: the key benefits of convertible debt 
• What are the potential risks of convertible debt?

Let's get into it. 

What is convertible debt?

Convertible debt is a financial instrument initially structured as a loan, allowing companies to borrow money with the potential to offer lenders equity in the future. Essentially, it's a hybrid between debt and equity, giving it the flexibility to serve several strategic interests.

Convertible debt is particularly appealing because it can offer attractive benefits to both the company and the investor. For the company, it provides immediate capital without the obligation of regular interest payments or the dilution of existing equity. For the investor, it carries the priority of debt with prospect of equity at a favorable price in the future. We'll explore these and other benefits in more detail below.

The ‘convertible’ aspect of convertible debt is usually tied to qualifying events, which can include successfully concluding a follow-on round of financing or achieving specific financial metrics. This ensures that both parties remain satisfied with the investment's terms while the company grows and achieves its strategic objectives.

When is convertible debt most commonly used? 

Convertible debt is most commonly used by companies in their early stages of growth. It is particularly beneficial for startups looking to secure capital without immediately diluting their equity. Many early-stage companies use convertible debt during seed financing rounds as a bridge to an equity round, which allows them to postpone valuation until further progress is made on business plans. 

This form of debt is not limited to startups, however. Scaling and stablished companies might employ convertible debt to raise capital in “bridging” rounds, especially in anticipation of a significant event, like a new product launch or strategic acquisition. 

How does convertible debt financing compare to traditional equity financing? 

A key distinction between convertible debt financing and traditional equity financing is the impact on company ownership and control. With traditional equity financing, you may need to offer investors a direct stake in the company, which often means diluting your ownership. Conversely, convertible debt offers an initial debt structure that only converts to equity under specified conditions, typically at a later stage of growth. 

This delay in equity conversion allows companies to preserve more control during crucial early growth periods. Convertible debt can be simpler to negotiate, making it an attractive option for those looking for a quick infusion of capital with flexible terms. Importantly, convertible debt often involves lower initial legal and administrative costs compared to equity financing due to simpler documentation and less immediate negotiating over the terms of investor ownership. 

Cost-effective financing: the key benefits of convertible debt 

So, what are the benefits of convertible debt for companies? Let's take these one by one. 

Cost-effective

Convertible debt can be a cost-effective financing option for those seeking innovative ways to fund their growth. It allows companies to leverage both debt and equity benefits, providing a unique hybrid of financial flexibility and reduced costs. By opting for convertible debt, companies can often reduce the otherwise hefty legal and administrative fees often associated with equity financing. 

Defer interest payments

One of the primary advantages of convertible debt is they typically include deferred interest, rather than requiring that interest payments be made currently in cash. Companies can enjoy the benefits of immediate capital without the immediate burden of high-interest debt survice, which can be particularly appealing for early-stage companies focusing on reinvestment into the business. The lower interest rates offered by investors in convertible debt as a result of its upside equity returns further enhance the attractiveness of convertible debt, allowing companies to manage their cost of capital more effectively.

Simplify documentation

Another vital benefit is the simplicity and speed of documentation of convertible debt, compared to other methods of financing. Equity raises may require significant due diligence in order to develop an agreeable valuation of the company; pure debt may involve negotiation of financial and operating covenants or require restructuring of a company’s cash management infrastructure. The often streamlined process of negotiating a convertible debt instrument can take just a few days, meaning companies can quickly respond to market changes or opportunities. This pace allows businesses to focus their resources on strategic growth rather than becoming bogged down in administrative processes and delays in fundraising. 

Does not (immediately) dilute equity

Convertible debt does not immediately dilute equity, which can be a common concern for founders and existing stakeholders. Instead, it provides a mechanism to convert debt into equity further down the line, aligning the interests of the company and its investors. 

By adopting convertible debt, companies can embrace a strategy that supports their immediate financial needs and benefit from a financing method that preserves their long-term strategic goals. Whether seeking bridge-capital financing or avoiding premature startup valuations, convertible debt offers a blend of flexibility, speed, and cost-effectiveness, tailored to modern business needs.

What are the potential risks of convertible debt?

While convertible debt offers a range of benefits, it also comes with inherent risks that companies must assess carefully. 

• Impact on future equity rounds: If companies need to conduct future equity raises, outstanding convertible debt can complicate the process. Significant convertible debt can impact valuation and investor negotiations, making it challenging to structure subsequent funding rounds. 
• Repercussions of failed conversion: If anticipated equity rounds or conversion events do not occur, the debt remains on the company's balance sheet and may eventually mature and become payable. This situation can increase financial strain, especially if repayment terms are strict.
• Interest payment impact on cash flow: Even though convertible debt often allows for deferred interest payments, the obligation eventually comes due. This can strain a company's cash flow, particularly if financial projections fall short. 

Support with convertible debt 

Several options are available when it comes to financing your business, each with its benefits and risks. At Biztech Lawyers, we have the depth and breadth of legal knowledge to help you select the best option. Considering convertible debt? Discover how we can support you.