Convertible Debt Explained: A Founder’s Guide by Angel School

Wiki Article

Raising capital is one of the most critical decisions early-stage founders face. When valuation is uncertain and speed matters, convertible debt often becomes the funding instrument of choice. This guide breaks down convertible debt in simple terms—how it works, when to use it, and what founders should watch out for—brought to you by Angel School.

What Is Convertible Debt?

Convertible debt is a short-term loan that converts into equity during a future financing round, typically at a discount or with a valuation cap. Instead of setting a company valuation upfront, founders delay valuation until a later priced round, making convertible debt ideal for early-stage fundraising.

Unlike traditional loans, the intent of convertible debt is not repayment—it’s conversion into ownership.

Why Founders Use Convertible Debt

Early-stage startups often choose convertible debt because it offers:

• Faster fundraising: Less negotiation compared to priced equity rounds

• Deferred valuation: Avoids underpricing the company too early

• Lower legal costs: Simpler documentation and fewer complexities

• Founder-friendly flexibility: Useful during pre-seed and seed stages

For many first-time founders, convertible debt provides a practical path to secure capital while maintaining momentum.

Key Terms Every Founder Must Understand

Before signing a convertible debt agreement, founders should be clear on these critical terms:

1. Valuation Cap

The maximum valuation at which the debt will convert into equity. A lower cap favors investors, while a higher cap benefits founders.

2. Discount Rate

Investors receive equity at a discounted price (commonly 10–25%) compared to new investors in the next funding round.

3. Interest Rate

Interest accrues over time and converts into equity rather than being paid in cash.

4. Maturity Date

The date when the loan is due. If no qualified financing occurs by then, founders must renegotiate, repay, or convert the debt.

Understanding these terms helps founders avoid surprises later.

How Convertible Debt Converts into Equity

Convertible debt typically converts during a qualified financing round. At that point, the debt plus accrued interest converts into shares using either:

• The valuation cap, or

• The discounted price of the new round

Whichever option is more favorable to the investor usually applies.

This structure aligns investor risk with startup growth potential.

Convertible Debt vs Equity: What’s Better for Founders?

Convertible debt works best when:

• Your startup is very early-stage

• Valuation is difficult to justify

• Speed is more important than precision

Equity rounds are often better when:

• You have strong traction and revenue

• Valuation is clearer

• You’re raising a larger round

According to Angel School, many successful startups use convertible debt as a bridge to their first priced equity round.

Common Founder Mistakes to Avoid

Founders should be cautious of:

• Setting low valuation caps too early

• Ignoring the maturity date

• Stacking multiple convertible notes without a clear strategy

• Not understanding dilution impact

Education and planning are essential to using convertible debt wisely.

When Should Founders Choose Convertible Debt?

Convertible debt is ideal when:

• Raising a pre-seed or seed round

• Testing product-market fit

• Preparing for a larger priced round

• Working with angel investors

Platforms like Angel School help founders evaluate whether convertible debt aligns with their fundraising goals.

Convertible debt can be a powerful fundraising tool—when used correctly. It offers speed, flexibility, and simplicity, but it also carries long-term implications for ownership and control.For founders navigating early-stage fundraising, understanding convertible debt is not optional—it’s essential. With the right guidance and education from Angel School, founders can raise smarter, fairer, and more strategic capital.