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Comparing Convertible Debt and Venture Debt

Written by: Cecilia M. Frerotte, CPA

In our work with entrepreneurial clients, we have seen two major strategies for taking on debt: convertible debt and venture debt. You may be considering your options right now. Perhaps you have some investment from outside investors, but want to minimize dilution or you are looking to delay your next equity round to have time to further develop your product, increase sales or margins. Here’s what you should know about the two and how to determine which one may be right for your business.

Equity Considerations

Venture debt has a significant advantage to convertible debt in that there is no equity stake yielded to the investor. It is straight debt, you borrow and you repay. Convertible debt gives the holder a right to convert the debt into an equity holding, generally in a future round and commonly at a discount. In many early-stage companies it serves as a bridge to the next round of equity financing, so it’s best to think of it as your current investors buying in at today’s valuation and earning interest on-top of their investment.

Interest and Other Costs

Now for the not so great aspects of venture debt, it is expensive. Interest rates are generally high, a rate in excess of 10% is not uncommon. It is important to remember your Venture Debt holders are creditors, they will be interested in regular updates on your Company’s performance and you are committing to regular payments, which mean cash out of your business.

Convertible debt can be a significant lift to cash flow concerns in that it is often never intended to be repaid. Additionally, the stated interest rate will be significantly lower than Venture debt. If the debt is not repaid, it will likely convert to equity at significant discount, commonly 10% to 20%, meaning the debt holder is immediately “in the money.” On top of this discount conversion rate, the convertible note holders may also ask for warrant coverage based upon the dollars lent. The discount at conversion and warrant coverage compensate the debt holder for providing a lower stated interest rate.

What is Right for Your Business?

As you can see there are a number of things you should consider when making the determination to take on Venture Debt or go with Convertible Debt. Depending on where you are in your business lifecycle or what type of cash flow you have to be able to pay back debt might determine what is right for you. If you’re looking to minimize dilution, then Venture Debt might be right for you. If you more concerned with keeping cash in the business, Convertible Debt may make sense. In the end, make sure you speak with your advisors as to what might be right for your growing business.

This article was written with added perspective provided from Jane Mason, Managing Director Northeast Region at Novus Capital Group. For a more in-depth exploration of Venture Debt check out her article "What is Venture Debt?"