A convertible debt is a part of a company’s debt obligation that changes into stock upon the next funding round or becomes due as the result of maturity or other defined event.
Convertible debts are a flexible financing option, helpful for companies with high risk and reward profiles (like startups).
Convertible debt make it possible for startups without no valuation to raise money quickly and less expensively than equity. It’s often a more attractive alternative than a traditional bank loan as well.
Usually a convertible debt comes from an angel investor or a venture capitalist. These are rich people who want to help startups. They invest with convertible debt under the assumption that debt will change into equity in the company in a few years.
Convertible debt also helps a company to minimize negative interpretations by investors of what it’s doing with its securities. If a company suddenly chooses to issue stock, the market see that as a sign that the company’s share price is overvalued. To avoid this, the company can issue convertible debt, which bondholders will convert to equity as long as the company continues to do well.
Investors often demand a security with minimal downside but maximum upside. Go figure. If a startup has a risky project that loses a bunch of money but eventually leads the company growing, a convertible debt investor doesn’t lose much during the failure of the company and benefits later by converting the bonds into equity.
Convertible debts also allow companies to lower their borrowing costs. From the investor’s POV, a convertible debt is basically a bond with a stock option attached to it.
I’m using convertible debts to buy a convertible.