VC & PE Glossary
What Is Default to Equity?
Updated
Definition
Default to equity describes financing or deal structures where debt or preferred instruments convert into common or preferred stock upon a triggering event — often payment default or missed milestones.
Useful for: Founders, Investors
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.
Related terms
- Default — Default is failure to meet legal obligations under a contract — most often missing debt payments or breaching loan covenants — triggering remedies like acceleration, fees, or restructuring.
- Equity Kicker — An equity kicker is an extra equity grant or warrant attached to a debt or mezzanine investment—giving the lender upside if the company succeeds.
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Common questions
Short answers for founders, LPs, and operators