Convertible Debt in Plain English

Finance is a bit like a secret society in that it likes to obscure commonsense ideas with intimidating language. Loans become bonds, bond insurance becomes credit default swaps. It’s a way to separate insiders and outsiders and raise a protective moat around in-the-know practitioners.

Anyone who reads TechCrunch has heard of the term “convertible note,” and knows it’s a common way for early-stage investors to bet on startups. But it’s a hard-to-grasp term, even for someone like me with an economics degree and a year of an MBA under my belt. I recently learned exactly what it does and why it’s used so frequently, and wanted to share that knowledge in a no-bullshit way. It’s not super complicated, but if you’re a 22-year-old Y Combinator grad building your first company, and investors start making offers, don’t you already have enough on your plate without having to parse financial gibberish?

A convertible note is debt. It’s a loan. The details differ, but usually when someone writes you a convertible note for $100,000, you’re expected to pay it back, along with some interest, in 1-2 years.

But of course, no one really wants that to happen. That’s because of the “convertible” part of the note. The investor is hoping that instead of getting paid back, your company will become the next Dropbox or Airbnb, and at some point you’ll raise a real round of venture capital. At that point, the note will become equity, and instead of having the right to get paid back, the investor will have an ownership stake in your company.

Why do a convertible note instead of equity? In short, it’s simpler, cheaper, and less time-intensive than an actual equity investment. For one, an investor and an entrepreneur don’t have to negotiate the value of the company if they’re using a convertible note - they can let the valuation be set during the first equity round. This is particularly useful for really young companies with one or two people and little more than an idea.

Also, if an investor decides to buy 10% of your equity outright, you may need to become an LLC or a Delaware C Corp. There are costs and tax obligations that go along with that. In general, the costs associated with a note can be 1/10th or less that of equity financing ($500 versus $5000, say). Also, if you’ve taken an equity investment and then go bust a year later, it’s difficult (legally) to disentangle all the ownership stakes. If someone loans you a convertible note and you go bust, an investor can simply write off the investment.

Of course, as with all simple ideas, people have figured out ways to make them far more complex. As a founder, there are a couple key sticking points you need to know about:

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