In very early stage companies convertible debt is usually only available for small-ish rounds of financing or as a bridge financing mechanism between rounds. The types of investors who are willing to use convertible debt are usually angel investors, strategic investors (maybe a future customer), and very rarely an early stage VC (one example is the CRV quickstart program but there are others). This can also be a smart mechanism if you're raising money from friends and family as it provides some protection for everyone while still offering a reasonable upside.
We've found the easiest way to understand convertible debt is through examples so here is one way that a convertible note might be implemented.
Your venture is reaching a point where hitting some clearly definable and relatively near-term (usually a year at most) technical or sales milestones will position you to raise money from a top-tier investor in your space. However, you need a few hundred thousand dollars to buy some equipment or make an important hire.
You approach an angel investor who you know is interested in your company and they agree in principle to providing the funding you need. But when it is time to define the terms of their investment neither of you really knows where to start. What is the pre-money? What other rights do they get? Do they get down-round protection in the event that you have overvalued the company?
Convertible debt can help deal with this by delaying these types of conversations until the right people and information can be brought to the table. It works by pegging the value of the investment to a future valuation. In this case, assuming you were raising $300K, it might work like this...
- The investment of $300K is made without regard to a defined valuation but instead with a "conversion preference" or interest rate, or both, that is defined in a term sheet. In this case, let's assume the conversion preference is 20% and the interest rate is zero. Both of these terms should be dependent on how far in the future the conversion is predicted to occur and how risky the investment is.
- Your venture uses the money to buy some equipment or make some critical hires and hits the milestones that make it ready for a larger round of financing by a traditional venture fund...let's just say this take 6 months, though it has no bearing due to the 0% interest rate.
- After working with a venture fund to define a valuation for investment (the pre-money), you agree that your venture is worth $5 million. At that point (really at the closing of the venture round), your angel investors convertible debt investment will "convert" to equity and be worth the $300K they invested PLUS the 20% converstion preference, in this case $60K. So essentially, they will own stock in your company equivalent to $360K.
How much of your company this $360K represents, as a percentage, depends on how much the VC invests (see Post-money Valuation)...but regardless of the amount, your angel investor will own the same dollar amount in stock.
Some great resources for learning more about convertible debt:
Raising Money Using Convertible Debt from Entrepreneur.com
The benefits of debt vs. equity in a seed round from Venture Hacks