Default to equity refers to provisions where failure to pay or perform under a financing agreement automatically converts debt or hybrid instruments into equity rather than forcing immediate cash repayment or liquidation.

How it works

Structures vary:

• Convertible notes may auto-convert on maturity if no qualified equity round occurs
• Venture debt sometimes includes equity kickers — warrants that expand or convert on default
• Structured preferred may flip to common at punitive rates if revenue covenants break

The conversion price matters enormously. A default conversion at a low cap or heavy discount can obliterate common shareholders while keeping the company operating under creditor ownership.

Lenders accept default-to-equity when they believe in long-term value but need downside protection beyond cash interest. Founders trade dilution for time.

Boards should model dilution scenarios before signing — not only base-case repayment.

Why it matters

• Founders: Treat default conversion as a last-resort equity round you did not negotiate openly. Push for clear caps and board consent requirements.
• Investors: Later equity holders analyze whether prior debt converts ahead of them in the stack. Subordinated agreements and intercreditor terms become critical.

Common mistake

Viewing venture debt as “non-dilutive” without reading default and warrant conversion language. Many cap table surprises originate here.

Related ideas

See also default, equity kicker, convertible note, and warrant coverage.