I get frequent questions from founders navigating convertible debt for the first time. Convertible debt can be an excellent financing tool, but it’s also complex and nuanced. Here are some of the questions I’m most often asked. Feel free to reach out if there’s something you’d like me to add!

How do I represent convertible debt on my cap table?
Because convertible debt will eventually convert into shares, but the exact number is initially unknown, many companies keep convertible debt off their cap table in the early stages. Instead, maintain a ledger listing each note’s details, including the holder, principal amount, issue date, and accrued interest. This way, when you prepare your Series A cap table, you’ll have all necessary information in one place. Many startups also use cap table management platforms, like Carta, that track convertible notes.

What’s the typical size of a convertible debt round?
Convertible debt rounds can vary widely, from small “friends and family” raises under $100,000 to larger rounds exceeding $5 million. For startups targeting venture capital, an initial convertible debt raise usually ranges from $500,000 to $2.5 million. As raise sizes increase, investors might push for more structured equity rounds to define control and ownership details.

Why would I choose convertible debt over an equity financing?
Convertible debt can be faster and less expensive than a formal equity round, especially for early-stage startups. The structure allows companies to defer valuation decisions until later, which can be beneficial when a company’s worth is still uncertain. However, the right choice depends on context—don’t pass up a strong investor just because they prefer an equity structure over convertible debt.

Can I bring in convertible debt investors at different times?
Yes, convertible debt rounds are designed to allow for multiple closings. If you’re targeting a $1 million round and have an initial $100,000 commitment, you can start with that. To help close additional investors, try grouping closings, which creates urgency and a clear timeline for final commitments.

What happens if we reach the maturity date without a conversion event?
If your notes reach maturity without a conversion, repayment terms kick in. However, it’s common for companies to negotiate an extension or conversion option with noteholders, as they usually prefer future equity over immediate repayment. Most investors don’t want repayment but rather an equity stake, so “majority rules” provisions in your note agreements can help extend maturity dates smoothly.

How does an “acquihire” impact my noteholders?
In acquihire situations, where the acquirer is primarily interested in hiring the target company’s team, convertible noteholders could face challenges if the acquirer doesn’t provide enough cash to repay them. Options include negotiating with the acquirer to add sufficient cash for note repayment or reaching an agreement with noteholders to accept less than the owed amount.

What is “warrant coverage” in a convertible debt round?
Warrant coverage offers noteholders the right to buy additional stock at a preset price, similar to an option. Warrants serve as a sweetener in some rounds, typically for lead investors or as an incentive to secure early commitments. While less common than discounts, warrants can appeal in larger deals, providing additional upside without immediate cash expenditure. Always consult tax counsel before including warrants, as they can carry tax implications.

What does it mean when an investor requests a “security interest”?
A security interest grants debt holders a priority claim on specific company assets if the company defaults. While rare in early-stage convertible debt, secured debt may emerge in distressed situations. Given the potential ramifications, consult legal counsel before granting a security interest to convertible noteholders.

What are pro rata rights, and should I grant them?
Pro rata rights (or participation rights) allow investors to maintain their ownership percentage by participating in future financings. These rights are increasingly common, especially with institutional investors, and allow holders to invest further in subsequent rounds. Pro rata rights typically apply only to the immediate next financing and are calculated based on the investor’s ownership before the financing.

If I need additional funds after an initial debt round, can I issue more convertible notes?
Yes. You can either extend the terms of the existing notes, with investor approval, or start a new round with updated terms if your company has made significant progress since the initial round. While investor approval may not be required, keeping early investors informed promotes transparency and helps maintain strong investor relationships.

What if I raise an equity round that doesn’t meet the “qualified financing” threshold?
If your convertible debt is structured to convert automatically above a certain financing threshold (typically $1-2 million), and your next round doesn’t meet it, you’ll need to negotiate with noteholders. New investors often prefer not to carry unconverted debt on the books, so discussing options with both groups before closing the round is ideal.

How does bank debt rank compared to convertible notes in the event of liquidation?
Generally, bank debt takes priority if secured, meaning banks have first claim on assets if the company dissolves. Convertible notes are often unsecured and have equal priority unless otherwise specified, meaning noteholders are likely next in line but behind secured creditors.

What if my company can’t repay the notes—can investors take control of the IP?
Technically, if notes mature and repayment isn’t possible, investors could seek action to recover their funds, but this is rare for early-stage investors. Early-stage noteholders typically prefer flexibility, understanding that aggressive recovery actions may not maximize their investment or value.

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