How convertible debt works with simple explained example

A start-up company without a credit history doesn’t have an established track record and therefore lacks credibility with conventional lenders such as banks. Therefore, most start-up companies prefer to raise fund from investors. In order to raise fund via equity, most start-up companies need to calculate their face value. But, at the beginning stage of companies, it is impossible to figure out and calculate the business value. So, the convertible debt notes were primarily created to help start-up companies raise fund.

Convertible debt known as convertible bond or convertible note is a way for a business to borrow money by entering into an agreement whereby it can repay the loan in shares of its own stock. With convertible debt, a business owner borrows money from a lender known as an early round private VC or angel investor. Both parties agree to enter an agreement to repay the loan by converting it into number of common shares in the future. The loan agreement outlines issuance date, maturity date, timeframe, the price per share for conversion and the interest rate will be paid. Thus, lenders prefer the convertible debt because the borrowers will pay the fixed rate of interest with option to convert it stock. If the lenders do not want to convert the bonds to equity, they will receive the convertible debt’s face value at the maturity date. However, if the lenders convert the bonds to company equity, the bond will possess only equity features instead of debt features.

On the other hands, the fast growth companies with lower credit score prefer issuing convertible debts once they believe that the business value will increase over years in the future. So, the equity dilution will be reduced in order to protect shareholders. For example. If the company A want to raise $10 million and its share value is worth only $10, it would have to sell their 1 million shares to meet the target. Via the help of convertible debt, they can wait until the company share is worth $100 per share and sell only 100,000 shares.