How does Convertible Debt work?

Let’s start by understanding that because we are talking about something called “Convertible Debt”, it means that whatever it is will start out as one thing, and potentially convert (or “change”) into something else. In this case, what the investor receives in exchange for his or her cash starts out as debt, and potentially converts into equity.

Debt is a fancy word for a “loan”. That is, I lend you money, and you agree to pay back the money that I loaned you at some known point in the future, along with a specific additional amount of money (called “interest”) which is your payment to me for having been willing to loan you money in the first place.

Equity is a fancy word for “ownership”. That is, I give you money and you give me part ownership of the company. Because I’m now an owner right alongside you, you don’t ever have to pay back the money to me (remember, it wasn’t a loan), and even if the company goes broke you still won’t owe me a penny. HOWEVER, also because I’m now an owner right alongside you, I get my share of any increase in value that ever happens with the company.

The difference here is that debt results in a fixed payback regardless of whether good things or bad things happen to the company, while equity results in completely variable payback from $0 (if the company goes under) to potentially billions of dollars (if the company ends up being worth a lot of money.)

The key functional aspect of these two very different things is that if I’m putting, say $100,000 into your company as debt, the only thing we need to discuss is the interest rate that you’ll pay me for using my money until you pay it back. But if I’m putting it in as equity, then we need to decide what percentage of the company’s ownership I will end up with in exchange for my investment. To figure that out, we use the following math equation:

[Amount I'm Investing] ÷ [Company Value] = [Percent Ownership]

Therefore, since we can calculate any one of the three terms if we know the remaining two, and we already know how much I’m investing (remember, we said $100,000), in order to figure out what my ownership percentage will be after the investment, you and I need to agree on a way to figure out what the company valuation is (or will be) at the time I purchase my shares of stock.

So, if I were just going to buy stock in your company today, we would agree on a valuation today, I’d give you the money today, you’d give me the appropriate percentage of the company’s stock, and we’d be all set. But that’s NOT what we’re doing.

Instead, I’m loaning you the money today (for which, as you’ll recall, there is no need to set a valuation on the company). HOWEVER, since I really don’t want only my money back plus a little interest (heck, I can get that just by putting my money in a bank account, instead of into a very risky startup), we agree that at some point in the future I will be able to convert my loan into the equivalent of cash, and use that money to buy stock in the company.

But because that conversion is going to be happening at some point in the future, while I’m giving you the money today, we need to figure out a few things today, before I am willing to give you the money. Specifically, we need to decide (a) when in the future the debt will convert to equity, and (b) how we will decide the valuation of the company at that point in the future.

The answer to both turns out to be the same thing: we will wait until a richer, more experienced investor comes around and agrees to buy equity in the company. At that point we will convert the debt into equity(a) and we will use as the valuation whatever that other investor is using(b). However, the fact is that I was willing to invest in your company at a time when that other big shot investor was not, and you used my investment to make the company a lot more valuable (and therefore got a high valuation from the other investor) so it doesn’t seem fair that I should bear the early stage risk, but get the same reward as a later stage investor, right?

We solve this problem by agreeing that I will get a discount (typically anywhere from 10% to 30%) to whatever the other investor sets the valuation at…which is why we call this a Discounted Convertible Note.

But you know what? Although that sounds fair, it really isn’t  (or at least serious investors don’t think it is.) That’s because the more successful you are at using my original money to increase the value of the company, the higher the valuation the next guy will have to pay…and pretty soon the little discount I’m getting doesn’t seem so fair after all! For instance, if that same big shot investor would have valued your company in the early days at, say $1 million, but is eventually willing to invest in you at a valuation of, say, $5 million, that means you were able to increase the company’s value 500% using my original seed money.

But if my convertible note says that it will convert at only a 20% discount to that $5 million, for example (which, if you do the math, is $4 million), I would seem to have made a very, very bad deal! Why? Because I end up paying for your stock based on a $4 million valuation, instead of the $1 million it was worth in its early days when i was willing to make my risky investment! No fair!

So how do we solve this problem? What we do is say “OK, because I’m investing early, I’ll get the 20% discount on whatever valuation the next guy gives you…BUT just to be sure that things don’t get crazy, we will also say that regardless of whatever crazy valuation HE is willing to give you, in no case will the valuation at which MY debt converts ever be higher than, say, $1 million.” That figure is known as the “cap”, because it establishes the highest price at which my debt can ever convert to equity.

And that is why we call this form of investment (which these days is used by most angel investors) a Discounted Convertible Note with a Cap.

*original post can be found on Quora @ : http://www.quora.com/David-S-Rose/answers *