Convertible debt is pretty much what it sounds like: debt that can convert to equity. A convertible debt financing is similar to a traditional loan in that the company borrows money (often from angel investors, but sometimes from friends and family or even VCs) and commits to repay it with interest by the end of the term of the loan. Unlike a traditional loan, however, the entire principal and accrued interest will convert to equity at the option of the lender or automatically upon the occurrence of certain events. For example, if the company raises a round of venture financing the outstanding principal and interest usually automatically converts into equity of the same type as is being sold to the VCs. By tying conversion to a financing, the debt holders effectively piggy-back on the valuation determined by the equity investors.

A convertible debt financing is often called a “bridge” financing because it provides a company with the capital it needs to continue operations until the next round of venture financing. To compensate the convertible debt investor for the added risk of investing earlier, the conversion to equity is typically at a discount to the price being paid by the VCs (around 20-40% is customary) or the company issues to the convertible debt investor a warrant to purchase additional shares of the equity into which the principal and interest on the loan converts in the financing.

Convertible debt offers several other advantages over an equity financing for a very early stage company, but the most significant is probably that a convertible debt financing is a much simpler transaction and therefore can usually be completed at a much lower cost than an equity financing. If you’re only raising a small amount, the cost savings can be critical.

NOTE: Even though convertible debt starts out as a loan, it is still considered a “security” and therefore all the normal securities laws apply, including restrictions on sales to non-accredited investors, so be sure to consult your lawyer.