Loan Lesson

Is convertible debt the way to go?
Magazine Contributor
2 min read

This story appears in the September 2006 issue of Entrepreneur. Subscribe »

Question: I'm trying to raise money to start a business, but I'm confused about valuation. How am I supposed to know how much of the company to give away to investors when I have no idea how much my business is even worth?

Answer: Determining the value of a startup without revenue, profits or product is never easy. That's why many early stage companies bypass the VC route and choose to raise money through convertible debt, a type of loan that pays investors a fixed annual interest rate (say, 8 percent to 10 percent) and also gives them the opportunity to convert their debt to shares of the company's stock at an agreed-upon price when and if the company gets acquired or goes public. Investors also get downside protection if the business fails and the company defaults.

According to Ben Boissevain, managing partner of Agile Equity LLC, a boutique investment banking firm in New York City, convertible debt is attractive to entrepreneurs because the founders get to maintain control of the company's direction and may not have to dilute their equity as much as they would if they had sold shares from the start. For example, a software company looking to raise $500,000 can offer investors 10 units at $50,000 each with each unit paying 10 percent annual interest and convertible to equity at $1 a share. This way, if the company sells for $10 a share three years from now, the investor makes $500,000 on his investment plus the $15,000 in interest he has collected along the way.

However, Boissevain cautions, drawing up a convertible debt agreement requires legal and financial expertise--even savvy entrepreneurs should consult an attorney to help draft one.

Rosalind Resnick is founder and CEO of Axxess Business Consulting, a New York City consulting firm that advises startups and small businesses.

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