Convertible debt is a funding instrument for a company that combines attributes of debt and equity. The issuer of the convertible debt receives up-front investment cash but is not bound to any interest payments. At the end of the time horizon, the debt and all accrued interest payments are converted into equity in the company, often at a discount.
To get a better understanding of the way that convertible debt works, here is an example.
A startup company issues a $100,000 convertible note to an investor at a 5% interest rate. The debt will convert to equity at a 20% discount in the case of a capital raise of $500,000 or more. After a year, the company issues 500,000 shares at $1 per share for an investment of $500,000, which results in a conversion of the investor’s debt. With the accrued interest, the $100,000 is now worth $105,000. A 20% discount on the equity means that the investor gets shares for $0.80. At $0.80 per share, the investor can get 131,250 shares. With the shares valued at $1, the investor now has $131,250 of equity. This translates into a 31.25% return over that one-year time frame.
It is important to note that convertible debt does not apply a valuation to the company at the time of issuance, as no percentage of the company is attached the value. The valuation, as we saw, is applied at the time of a subsequent round of financing.