Advantages & Disadvantages of Convertible Debt

If you want to raise money for your small business without going public, convertible debt could be your answer. Unlike traditional loans, the goal of convertible debt is not to repay the money but to issue stock instead. Convertible debt is a loan secured by a written promise to pay, such as a promissory note. The loan is converted to stock at a certain point -- for example, when the company has $100,000 in sales. That stock is issued to the lenders at a discount.

By issuing convertible debt instead of stock, you remain the majority stockholder. You can issue preferred stock shares with no voting rights, to keep your lenders from having a say in how you run your company. Because it's usually cheaper and less time-consuming to issue convertible debt instead of stock, you'll get your money faster. With convertible debt, you don't have to worry about figuring out how much your company is worth to determine a stock share price.

Until the debt is converted into equity, you must service the loan according to the terms of the agreement. You might have to make periodic interest payments that could increase if the loan has an adjustable interest rate. If your business defaults on the loan, the lender could take legal action against your business. The Securities and Exchange Commission considers convertible debt a type of security, so you must comply with federal and state securities regulations when issuing convertible debt.

As a venture capitalist investing in a startup company, you can insist on a higher interest rate to compensate you for the additional risk. Depending on how the promissory note is structured, you might be entitled to regular interest payments. If the company succeeds, you can convert your loan to stock shares purchased at a discount. You have a good change of receiving repayment of your principal even if the company is only moderately successful. As a secured note holder, you are a priority creditor in case the company files for bankruptcy or becomes insolvent.

Until the loan is converted into stock, your money is tied up for the duration of the loan. If you receive preferred stock with no voting rights, you still won't be able to elect the members of the board of directors or have a say in company issues. If the company experiences financial hardships, your interest payments could be delayed indefinitely. If the company files for bankruptcy, you might receive only a portion, or none, of your principal investment back.