What is Convertible Debt?
Convertible debt is a financing term that is used to refer to any type of debt financing where there is the option of converting the outstanding balance due to some other form of security or asset. The term is used in reference to mortgages and other types of debt, as well as with various forms of securities. As it relates to a mortgage, convertible debt would be any type of arrangement that allowed the conversion of the outstanding balance owed into equity. This factor can come in very handy in the event that the borrower defaults on the repayment terms associated with the mortgage. The mortgage holder can choose to convert the debt into equity and thus be in a position to recover from the loss created by the default. In terms of other types of securities, such as a corporate security, convertible debt is sometimes used to refer to the ability to exchange one type of security issued by the corporation for a different type of security. For example, an outstanding bond issue that has te
Convertible debt financing is basically an investor loan to your startup that has a future conversion-to-equity feature. That is, your startup’s investor gives your startup a loan like a bank would, but the outstanding balance of this loan will convert to shares in your corporation at a future date. When does convertible debt convert to equity? Convertible debt typically converts to equity the next time your startup raises capital (think venture capital or similar large investor). Technically, this large raise is called a “qualified financing” per the convertible debt agreements (note and note purchase agreement). How does convertible debt convert to equity? Convertible debt converts to equity based on the valuation your startup receives from the venture capital firm in the “qualified financing.” For example, if your venture capital investor ends up paying $1 per share for your startup’s preferred stock and you have $800,000 of convertible debt, the investor will receive 800,000 shares
