Legal Definitions - convertible debt

Convertible debt refers to a type of loan that can be exchanged for ownership shares (equity) in the company that issued the debt, instead of being repaid in cash. It starts as a debt, meaning the company owes money to the lender, often with interest. However, under specific conditions outlined in the agreement, the lender has the option, or is sometimes required, to convert that debt into a predetermined number of the company's shares.

This financial instrument is often used by companies, especially startups, to raise capital because it offers flexibility. For investors, it provides the security of a loan (with interest) if the company doesn't perform well, but also the potential for significant returns if the company succeeds and its shares become valuable.

Here are some examples to illustrate how convertible debt works:

• Startup Seed Funding: Imagine a new technology startup, "InnovateTech," needs $500,000 to develop its initial product. An angel investor provides this money as convertible debt. The agreement states that when InnovateTech raises its next round of funding from venture capitalists, the angel investor's $500,000 loan will automatically convert into shares of InnovateTech at a discounted price compared to what the new venture capitalists pay. If InnovateTech struggles and doesn't raise more funding, the angel investor would still be owed their $500,000 plus interest, like a traditional loan.

  This illustrates convertible debt because the initial investment is a loan (debt) that has the potential to transform into an ownership stake (equity) upon a future event (the next funding round), offering the investor a chance to participate in the company's growth.

• Established Company Expansion: A growing manufacturing company, "Global Gears Inc.," wants to build a new, larger factory but isn't ready to issue new stock to the public. A private investment firm offers Global Gears Inc. a $10 million loan structured as convertible debt. The terms specify that after five years, or if Global Gears Inc. achieves a certain revenue target, the investment firm has the option to convert the outstanding loan amount into a 10% ownership stake in the company, rather than receiving cash repayment. If they choose not to convert, the loan is repaid with interest.

  Here, the $10 million is initially a debt. The conversion option allows the private investment firm to become a part-owner (equity holder) if the company meets certain performance milestones or after a set period, demonstrating the flexibility for both the company and the investor.

• Bridge Financing for a Biotech Firm: "BioHeal Pharma," a biotech company, is nearing the final stages of clinical trials for a promising new drug but needs $2 million for the last phase of testing. A venture capital firm provides a "bridge loan" in the form of convertible debt. The agreement stipulates that if the drug receives FDA approval and BioHeal Pharma subsequently completes a large Series C funding round, the venture capital firm's $2 million loan will convert into shares at a 20% discount to the Series C valuation. If the drug fails to get approval, the loan remains a debt to be repaid with interest.

  This example shows how debt can provide immediate capital and then convert into equity, often at a favorable rate, tied to a significant future event (FDA approval and subsequent funding), allowing the investor to benefit from the company's success.