Although this type of business financing is not as popular as debt or equity financing, more business owners need to be aware of it.
It is a middle ground between the two and offers an alternative for small businesses stuck between choosing a debt or equity funding structure.
“A convertible debt small business financing structure is a mix of debt and equity financing. The money raised is considered a loan, but at a future date, the loan can convert to equity if the lenders choose so”. In simple terms, it is a loan that can be converted to equity.
Why Does It Matter?
It offers much-needed capital for a business at a lower cost than a debt or equity financing would. It also helps a company lose less control by converting its debt to equity (share ownership) at a price that is set later.
With convertible loans, companies can postpone placing a valuation on the company, this can be useful particularly for seed-stage startups companies without enough operating history to properly set a valuation.
Of course, some of its disadvantages include the fact that as compensation, businesses would have to offer investors discounts on equity and if things don’t go as planned per the terms of the agreement, the convertible loan may become more expensive for the business.
Convertible loans are usually sourced from private investors.
After the business owner may have presented his/her pitch, the next step if the investors agree to invest is to set the terms of the agreement before the loan is disbursed.
This can include setting up a trigger event for when the loan can be converted to equity, setting a discount for conversion etc.
In setting these terms, a business owner but carefully evaluate the terms, clauses and implications because they would determine the cost of the investment in future.