Are you the owner of a growing business? Are you the genius behind the next “snuggie”? Are you the inventor of the next killer app? Unless your name is Paris Hilton, you will probably need to look further than your own purse to find the money needed to take your business to the next level. Assuming you have already used your savings, made your pitch to friends and family, donated the maximum amount of plasma, and run up the balances on your credit cards, you might be ready for more structured funding from more sophisticated investors. Every entrepreneur then faces a difficult decision: equity or debt? Convertible debt combines the benefits of both debt and equity.

Convertible debt is debt that can be converted into a company’s equity under certain conditions. This hybrid carries many of the same terms as regular debt (maturity date, maturity value, face value, and an interest rate) while allowing investors to capture the potential upside inherent in equity. One benefit to convertible debt for entrepreneurs is that it normally carries a lower interest rate than normal debt. This is due to the fact that the holder of the debt is compensated for this lower interest rate by the ability to convert the debt into equity at a discount upon a qualified financing event. A qualified financing event is defined as a new round of fundraising that is separate from the convertible debt offering. This acts as a trigger for the conversion of the debt into equity.

Like a trusty Swiss Army knife, convertible debt is a useful tool for a company. It is simple and flexible and can be issued at any time. Compared to an equity offering, a convertible debt offering can be closed faster and at a lower cost. Less time spent fundraising means more time to focus on a company’s opportunities. Furthermore, the use of convertible debt has increased substantially with the recent economic downturn and is becoming the financing of choice in many early stage financing transactions for seed capital (friends and family and angel investors).

Convertible debt also allows for the founders to retain control of the company. Convertible debt holders are not likely to demand board seats in return for their investment. By remaining in control, founders diminish the likelihood of disagreements between management and the board. While the founders do experience dilution of their ownership upon the eventual conversion of the debt into equity, the founders remain in control until the qualified financing occurs.

In addition, convertible debt may allow a company to access funds at a lower interest rate than normal debt (due to the discount mechanism) and can give a company flexibility with its payment structure. For example, a company could (a) forgo interest payments and instead roll all accrued interest into the principal (giving the investor more equity upon conversion) or (b) negotiate a grace period before the repayment obligations begin (giving the company breathing room to ramp up its business before making interest payments). If a company does decide to make periodic interest payments, the interest is deductible.

Lastly, convertible debt allows a company to avoid setting a valuation. This is a complicated and uncertain process for any company but especially for one that is in the start-up stage. Convertible debt eliminates the risk of a “down round” (when a later investment has a lower per unit price than the previous round). Furthermore, the amount of dilution a founder suffers from convertible debt is much less than the dilution suffered by setting the valuation too low in an initial equity round.

Unlike an elephant ear at the State Fair, convertible debt is not perfect. It differs from equity because convertible debt does come with repayment obligations (unless it is negotiated otherwise). Most early stage companies struggle with cash flow, so these repayment obligations can be an additional stress. Remember, it is debt, so these “lenders” may have the right to enforce repayment unlike an equity owner.

But the biggest drawback is the misalignment of incentives that convertible debt can cause. It is in the best interest of the convertible debt holders for the company to have a low valuation in the next round of funding. A low valuation translates into greater ownership of the company by the convertible debt holders and the new investors at the expense of the founders. Because the debt converts into equity at a price equal to or discounted from what the next round of investors pay, the lower the price, the more the convertible debt holders will own. On the other hand, the founder wants the valuation used for the next round to be as high as possible. One solution is for the company to place a “maximum conversion” valuation which places a ceiling on the valuation under which the debt converts. This helps to encourage early investors to actively work to increase the value of the company without causing them too much pain when the debt converts.

Like Ben Affleck to Matt Damon, convertible debt could be an entrepreneur’s best friend. Please contact Nick Mathioudakis with any questions. [Editor’s Note: Nick is an experienced attorney and entrepreneur who has counseled many companies during their formation and funding. He also plays a mean “Guitar Hero”. Lastly, Art covets but does not own a “snuggie”.]