One of the biggest challenges that any business can have is raising capital necessary to fund working capital and allow for growth. When looking for an option for raising capital, one great option would be to raise convertible debt from a group of investors.
This article will discuss what exactly convertible debt is, and what the benefits of it are for the business. You can also see what the potential drawbacks will be, and what a business can do to mitigate those risks.
What Is Convertible Debt?
Convertible debt is a complex financial instrument that a business can use to raise money. Also, an equity investor may try it to invest in a company. Convertible debt occurs when a company ends up borrowing money from:
- A private equity company;
- Venture capitalist;
- Other group of investors.
As opposed to other types of loans in which the loan will be paid off at some point in the future, the main intention of a convertible debt loan is that the loan will convert to equity at some point in the future. When the loan converts from debt to equity, the investors will convert from being a lender to an equity owner in the underlying company.
The structure of a convertible debt agreement will vary considerably from one agreement to the next. During the early portion of the agreement, it will have standard features of a loan including:
- Interest rate;
- Main payments;
- Other standard features.
A convertible debt agreement will also spell out a number of different features regarding when the debt will convert to equity. Some of the factors that will be spelled out in the conversion process will include:
- When the conversion will happen;
- What milestones need to occur;
- How much the equity interest will be;
- What level of control the new investors will have;
- Whether there will be any discounts provided to the initial investors.
What Are the Benefits of Taking Out Convertible Debt?
There are many advantages of providing convertible debt that a business should be aware of.
- One of the main advantages is that it helps them to raise more capital. Those that provide the debt will be able to also provide a wide range of capital options. You can use the options to act as working capital, inventory, market, research, fuel growth, and complete a wide range of other tasks. They are also often willing to provide cash flow based loans, which is something that may not be possible for smaller businesses.
- Another advantage of taking out the convertible debt is that it can be a more affordable debt option with cash flow advantages. The interest rate on these types of debt agreements is often very low compared to other types of high-leverage financing. Investors know that ensuring you have more cash flow is beneficial to the viability of the business. So, they are not always necessarily interested in earning a big profit on the interest rate and fees. Furthermore, investors often allow you to delay interest payments. This can help to maximize your current cash flow.
- The third advantage of taking out a convertible debt note is that it can connect you with more individuals that are experts in the industry. Equity investors from institutional funds tend to be very skilled in their industry. While they will not necessarily have control of your firm, they can continue to provide valuable insight into the direction of your company. Furthermore, they will be able to connect you with other people and resources that could help to grow your firm.
What Are the Potential Risks?
While there are some clear advantages that come with taking out a convertible debt loan, there are drawbacks as well that you need to be aware of.
- The main disadvantage is that you will be giving up some ownership of your company. The debt providers will often want a fixed percentage of your company after the debt converts to equity. Furthermore, they will likely negotiate a pre-determined valuation during the contract period. This could be a significant discount if your business continues to succeed. While this risk is prevalent in all transactions, the risk is typically outweighed by the benefits that the equity investor can provide.
- The second risk of taking out a debt instrument from the investors is that it could cause significant financial issues down the line if the business plan does not work out. Let’s say the debt provided does not fuel enough growth and your firm begins to lose money. Then, the investors will likely not want to convert the debt to equity. In these situations, you will still be responsible for repaying the debt. Depending on the structure of the loan, this could end up forcing you and your business into bankruptcy. Moreover, it could prevent you from taking out other types of debt.
How to Mitigate Risks?
While there are risks with convertible debt agreements, there are ways to mitigate these risks. The main way to mitigate it is to have a trustworthy counsel the agreement fully vet and review the agreement. Just make sure that the counsel has experience in dealing with these agreements.
They will be able to ensure that you are able to retain an appropriate level of equity in your firm and will be able to explain what the downside risks are. Based on this consultation, you will be better able to determine whether a convertible debt agreement is right for you.
In conclusion, finding ways to raise capital is a very important requirement for all businesses that are looking to grow. One unique way to raise capital would be through a convertible debt agreement. These agreements can provide a borrower with a range of benefits that can help them to grow and maximize cash flow.
However, there are some risks and downsides that you need to fully consider and vet from these agreements before executing the agreement.
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