Convertible debt is a good way to fund a bridge in your capital fundraising. Bridge financing refers to the tactic in which a little bit of money is accepted now to help the company get to a lot of money in the future. Bridges should occur only when a very high expectation of the future inflow of cash exists.
Convertible debt ensures a company has cash on hand as it approaches a Series A round. If you have a commitment for a future close date or are just waiting for a fairly certain funding incident, convertible debt can fill the bill nicely.
Entrepreneurs like convertible debt because it’s fast, cheap, and allows them to grow without giving up equity until a later date when it may be worth a lot more and can be sold at a premium price.
Convertible debt is fast and cheap because all the provisions and terms don’t have to be negotiated and no preferred stock is issued. (Attorney’s fees can get quite steep with preferred stock and equity.) Convertible debt requires just a quick, few-page contract.
Entrepreneurs also like convertible debt because it puts off the question of valuation. Valuing an early-stage company is hard, and convertible debt is one way of delaying that difficult task.
Plus, the ultimate value of the company comes later, when a venture capitalist (VC) invests and sets the price for the round. If the VC invests at $1 per share, then the convertible debt holders can buy stock up to the value of their initial investment for $.80 per share.
Investors who buy convertible debt get the stock cheaper because they committed to the deal a few months prior. When they committed, the deal looked different, more risks existed, and the company wasn’t as developed.