Five-minute general counsel: when should I consider a convertible bridge?

I have more than one client currently considering convertible bridge notes as a parallel angel/seed round funding technique, and I have one who recently closed a small convertible note that will convert in the upcoming seed round.

What’s a convertible bridge note?

A convertible bridge note is a not-uncommon financing instrument in venture capital. This instrument is very common when an investor has effectively decided to invest and wants to give the company operating capital while the investment is finalized.But that’s typically just referred to as a bridge note whereas “convertible bridge note” is more a term of art referring to the instrument and technique I describe here.

This type of note functions like any other, but a few additional terms are often added: first, the note has more particularized conversion requirements that are tailored to what the parties expect will be an outside round with a more reasonably precise valuation; second, the return for the note investor will include both some element of interest and some additional return; third, the additional return, which is designed to mimic or at least make up for the equity return that would have otherwise been gained via a seed equity investment, consists of either a fixed return, regardless of time, or a fixed rate of return, regardless of amount.

Why would anyone do this?

The rationale for convertible bridge notes is part of the continuing fuzziness of venture investing (still reaching back, in my mind, to the dotcom bust), along with some recent discussion by Fred Wilson of why he finds himself not attracted to these sorts of deals. (I’ve got a need to do a whole series of posts on some of the issues Fred raises in this post; the guy writes stuff that opens a whole host of issues, which might be one reason this post, by no means unusual, had 135 comments at last visit.)

For the earliest stage startups, there is a high variance in terms of coming up with a reasonable valuation. Standard seed round terms and conditions make it easier to avoid trying to price any of those items (which I’m convinced no one does, has done, or will likely ever do with intent or knowledge). But every company still faces the three inherent risks (the VC triumvirate): technology risk, market risk, and operations risk (aka team risk). These have otherwise been described as “Is there a real market?” and “Is this the right team?” These risks don’t go away just because you standardize terms, and their impact on valuation often falls into the realm where reasonable people might disagree — can prices be maintained? How much can sales be ramped up? How long will the sales cycle be?

When the right set of risks is hindering the deal, then a skilled corporate lawyer (e.g., me) may suggest using a convertible bridge note to allow the parties to do the deal they want, which is fundamentally about allocating capital to the pursuit of the business’s objectives, and deferring the open question, valuation, in a way that is fair to both sides, investor and company.

In short, the convertible bridge note is properly employed when both sides want to do the deal, believe in the company and its prospects, want to treat each other fairly, and would rather get the “right” answer than disagree and kill the deal. (Note how the critical point here is plainly addressed in Fred’s post:

But I am a sophisticated investor. I do this for a living. I can negotiate a fair price with an entrepreneur in five minutes and have done that for a seed/angel round many times.

Investors

For angel investors, the use of a convertible bridge note has certain advantages over either a seed-round Series A or common-stock financing. First, the question of valuation is deferred in exchange for a known return from the time of the investment to a future valuation event. This deferment reduces the risk for investor and company that the valuation arrived at may differ greatly from the future financing, thus being somewhat “unfair” to either investor or company. When the angel investor and the company both want to treat the other fairly, this financing method helps eliminate the risk of unfairness.

Second, the note is debt, which gives the investor priority over other equity investors (similar to the priority in liquidation of preferred stock).

Third, the technique is common and well-understood by venture funds, so there is little risk of inadvertently creating potential problems in the structure.

Fourth, the auto-conversion terms can protect both parties by substituting the more formal, and often more extensive, rights of a Series A holder for rights under the note that can then be tailored to specific circumstances.

Fifth, a bridge financing can be completed in days versus weeks or longer for a preferred stock financing, in part because of the seniority of the debt over the equity and different regulatory requirements.

Sixth, the bridge note is a substantially cheaper transaction in terms of legal fees and other transaction costs.

Company

What’s in it for the company and founders? Simple: they get to bet on themselves and use the investor’s capital to do so. If the only possible structure were an equity round, founders would be constantly torn between their view of valuation based on their view of the assumptions about execution and the investor’s view on the same thing. There are always ancillary ways of tweaking the analysis, but few of them work well for startups (earnouts is a good example of something that works in a public company context where the valuation is relatively fixed).

If founders execute according to their plan, they will retain more of the company (by way of an effectively lower valuation for the bridge money) than if they don’t execute as well. But under either scenario, the investor and the founders are moving in the same direction and with the same vision. Both want the company to do better rather than worse, and preserving that joint mission is, to me, the best part of why bridge notes work under the right circumstances.

The reason I list as #6 above, transaction costs, is really one of the worst rationales, and I’m close to removing it from this list. I have a former client whose company was choked to death, and then his personal life nearly ruined, by maintaining a convertible debt structure for far too long. They just never got around to cleaning everything up, and much like my objections to LLCs, the looser regulatory framework can lead a company quickly down the path from efficiency to complacency.

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