In startup financing, convertible debt has emerged as a smart way to bridge the gap between early-stage funding and long-term investment. It’s an investment instrument that blends the features of both bonds and stocks, offering flexibility for startups and balanced risk-reward for investors.
In simple terms, convertible debt allows investors to lend money to a company while earning interest, just like a traditional bond. However, if the company performs well, investors can convert their debt into equity at a future date, usually during the next funding round.
In this blog, we’ll explore convertible debt, how it works, key terms you should know, who should invest in it, its benefits for startups, and the step-by-step process for raising funds through this model in India.
Table of Contents
What Is Convertible Debt?
Convertible debt, often called a convertible note, is a type of short-term loan that startups or early-stage companies use to raise capital. The debt earns interest (typically 8–14%), similar to a bond, and can later be converted into equity shares instead of being repaid in cash.
The conversion usually happens during a future financing round, when the company raises money from institutional or venture capital investors. The early investor’s loan is then converted into equity at a discounted price, rewarding them for investing early.
It combines the fixed-income security of debt with the growth potential of equity, making it an attractive choice for both startups and investors.
Essential Terms in Convertible Debt Explained
Before investing in or issuing convertible debt, it’s important to understand its key terms- each of which plays a role in determining returns, risk, and equity ownership:
- Interest Rate: The annual rate (typically 8–14%) that accrues on the loan amount until conversion or repayment. It compensates investors for the time value of money and associated risks.
- Conversion Discount: A percentage discount (usually 10–30%) offered to investors when their debt converts into equity during a future funding round. It rewards early investment at a lower share price.
- Maturity Date: The date when the debt becomes due. If the company doesn’t raise a qualified round by then, the investor can demand repayment or negotiate conversion terms.
- Valuation Cap: A ceiling on the company valuation for conversion purposes. It ensures early investors receive a favourable equity conversion rate even if the company’s valuation skyrockets in later rounds.
Who Should Invest in Convertible Debt?
Convertible debt is ideal for investors who want a blend of safety and upside potential. It suits:
- Angel investors looking to participate in early-stage funding without the complexities of equity pricing.
- High-net-worth individuals (HNIs) seeking regular interest income with the opportunity to convert into equity later.
- Venture funds exploring strategic early exposure to promising startups before a priced equity round.
This investment route offers downside protection through interest and repayment options, while giving investors a potential equity windfall if the startup succeeds.
How Convertible Debt Works: Key Mechanisms
Here’s how convertible debt operates in practice:
- Issuance:
The startup issues a convertible note to investors, specifying terms like the interest rate, valuation cap, maturity date, and conversion discount. - Interest Accrual:
Investors earn regular or accrued interest on the principal amount during the loan period. - Conversion Event:
When the startup raises a qualified financing round, the convertible debt automatically converts into equity shares at a discounted rate or based on the valuation cap. - Repayment Option:
If no qualifying round occurs before the maturity date, investors can extend, convert, or demand repayment.
For instance, suppose a startup raises ₹50 lakh in convertible debt at a 20% discount with a valuation cap of ₹10 crore. If the next funding round values the company at ₹15 crore, the investor’s conversion happens at ₹10 crore- ensuring more shares and higher equity value.
Benefits of Investing in Convertible Debt for Startups
Convertible debt offers several benefits that make it a win-win arrangement for both startups and investors:
For Startups:
- Quick Fundraising: No need for immediate valuation negotiations.
- Lower Dilution: Founders give up less equity compared to direct equity funding.
- Flexibility: Terms can be negotiated and structured to match growth plans.
For Investors:
- Downside Protection: Investors earn interest and can seek repayment if conversion doesn’t occur.
- Equity Upside: Conversion allows participation in future growth and valuation appreciation.
- Balanced Risk: Combines fixed-income safety with startup growth potential.
The Process of Raising Convertible Debt
Raising funds through convertible debt in India involves both legal compliance and structured execution. Here’s a step-by-step guide:
- DPIIT Registration:
Ensure the startup is recognised under the Department for Promotion of Industry and Internal Trade (DPIIT) to access benefits and investor confidence. - Compliance with FEMA:
If funds are raised from foreign investors, comply with Foreign Exchange Management Act (FEMA) regulations to ensure equal inflows. - Filing with Registrar of Companies (ROC):
File the convertible note agreement and related disclosures with the ROC as per the Companies Act, 2013. - Drafting the Convertible Note Agreement:
Define key terms- interest rate, maturity, discount rate, valuation cap, and repayment clauses- clearly in the agreement. - Negotiation & Execution:
Discuss terms with investors, finalise documentation, and execute the agreement legally. - Receiving Funds:
Once executed, funds are transferred to the startup’s account as debt, reflected in financial statements accordingly. - RBI Reporting:
For foreign investments, submit Form CN (Convertible Note) to the Reserve Bank of India (RBI) within 30 days of fund receipt.
Frequently Asked Questions (FAQs)
Private Limited Company
(Pvt. Ltd.)
- Service-based businesses
- Businesses looking to issue shares
- Businesses seeking investment through equity-based funding
Limited Liability Partnership
(LLP)
- Professional services
- Firms seeking any capital contribution from Partners
- Firms sharing resources with limited liability
One Person Company
(OPC)
- Freelancers, Small-scale businesses
- Businesses looking for minimal compliance
- Businesses looking for single-ownership
Private Limited Company
(Pvt. Ltd.)
- Service-based businesses
- Businesses looking to issue shares
- Businesses seeking investment through equity-based funding
One Person Company
(OPC)
- Freelancers, Small-scale businesses
- Businesses looking for minimal compliance
- Businesses looking for single-ownership
Private Limited Company
(Pvt. Ltd.)
- Service-based businesses
- Businesses looking to issue shares
- Businesses seeking investment through equity-based funding
Limited Liability Partnership
(LLP)
- Professional services
- Firms seeking any capital contribution from Partners
- Firms sharing resources with limited liability
Frequently Asked Questions
Is convertible debt safe?
Convertible debt offers a balance of safety and growth potential, but it’s not entirely risk-free. It provides investors with interest income and the option to convert their loan into equity if the startup performs well. The safety comes from the debt structure- meaning the company is still obligated to repay the principal if conversion doesn’t happen.
What is a valuation cap in convertible debt?
A valuation cap sets the maximum company valuation at which convertible debt can be converted into equity. It protects early investors by ensuring they receive more shares if the startup’s valuation increases significantly before conversion.
How does convertible debt benefit investors?
Convertible debt benefits investors by offering:
- Fixed returns through interest payments, similar to bonds.
- Upside potential via equity conversion if the startup grows or raises capital at a higher valuation.
- Downside protection, since it starts as debt, which gives investors priority over shareholders if the company faces liquidation.
When is the best time for a startup to use convertible debt?
The best time to use convertible debt is during early or bridge funding rounds, when a startup needs capital but doesn’t want to fix a valuation too early. It’s ideal between the seed and Series A stages, especially if the business expects rapid growth or a higher valuation soon.
What happens if I don’t convert my convertible debt into shares?
If convertible debt isn’t converted into shares- either because the investor chooses not to or the conversion trigger (like a new funding round) doesn’t occur- the company must repay the principal and any accrued interest by the maturity date.
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Swagatika Mohapatra is a storyteller & content strategist. She currently leads content and community at Razorpay Rize, a founder-first initiative that supports early-stage & growth-stage startups in India across tech, D2C, and global export categories.
Over the last 4+ years, she’s built a stronghold in content strategy, UX writing, and startup storytelling. At Rize, she’s the mind behind everything from founder playbooks and company registration explainers to deep-dive blogs on brand-building, metrics, and product-market fit.
