The Debt Has Two Faces

This story appears in the February 2000 issue of Startups. Subscribe »

Convertible debt is a loan that can convert to equity under a certain set of prearranged circumstances-usually when the lender says so. If your company succeeds, the lender becomes an investor; if you break even or go into the red, they simply remain your lender.

For someone betting on an entrepreneur's idea and its potential for success, convertible debt creates a win-win situation. If the company is a success, the lender gets to participate as an equity investor. If the company does just so-so and can't foresee any exit opportunity, the lender can still call for repayment of the loan at the end of the term.

Although termed a loan, this is really high-risk equity. If you're having a hard time reeling in lenders, consider adding convertible debt as a deal sweetener, advises Michael Troy, who launched KnowledgePoint from his home in 1987. Convertible debt made sense to Troy, and his little start-up has since grown into one of the leading developers of human resources management software. Troy lauched his business with $76,000 from friends and family.

"We learned that, unlike equity, a convertible plan would pay a good rate of return from the outset, and offer investors the chance to convert to equity, with its upside potential, at a date later in the company's development," says Troy.

Troy emphasizes the need for any financing deal that includes a conversion feature to include specific details in its offering prospectus, explaining exactly how and when investors can convert. Toward that end, he structured the company's debt to pay investors a guaranteed quarterly rate: five percentage points above prime, capped at 15 percent. After five years, the company would return the principal to all investors who had not, within a specified period, chosen to convert the debt to common stock.

The experience worked so well that in 1995 Troy again used convertible ventures, this time to raise $500,000 to maintain status as an S corporation and all the tax advantages that go with it. He expects all the investors will convert to equity before the loan comes due.

When should you consider using a convertible-debt arrangement? Experts suggest the following conditions:

• When you have a trusted attorney who can provide insight as well as draft the agreement

• When you can use it to negotiate better terms, like lower interest rates

• When you can use it to convince a hesitant financier to make a commitment

Conversely, convertible debt is not recommended if you can do something simpler-like obtain a regular loan or a normal investment. Just remember, you want to retain as much control as possible over threshold that will ultimately trigger the conversion from debt to equity. You'll need an attorney and a CPA who have handled convertible-debt deeds before and who understand the impact of IRS regulations vs. company valuation at the time of conversion. And beware of lenders who start thinking of themselves as investors too early in the game.