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.

As I think about it now, I suppose I should edit to make that point clearer. But it’s there even without the keywords. I’ll explore this framework further on Simplifying Complexity if there’s interest: are you interested?

Does this treatment of pension “earnings” hold true at your companies, or have more interested boards at most companies cleaned this up? I support the use of free cash flow as the primary metric for executive compensation, although a detailed FCF analysis might give a board specific sub-targets for a C-level officer to achieve in pursuit of higher FCF. None of those, however, would be likely involve pension earnings or stock split numbers.

(On a related note, I was wondering whether seemingly “senseless” increases or decreases in pension plan earnings assumptions serve as an early indicator of operating and stock performance.)

Short answer: you should probably just buy insurance instead.

Entity types to consider include the corporation (with S- or C- taxation), limited liability companies (LLCs), partnerships, sole proprietors, and a few other entities with specialized application (such as the limited liability partnership for law firms).

The reason these entities exist is for limited *liability.*

The decision path to entity formation and selection should start with risk analysis and risk management. The two significant questions that you have to answer to decide whether this is the right course for you are: “What is my potential liability? and “What do I have to protect?”

What is your potential liability?

For example, if you’re going to be writing articles or conducting information research for corporate clients, then your primary risk is going to be from a generic commercial litigation issue. Based on the types of problems you’re most likely to encounter, errors and omissions insurance is the general type you would want to consider. If you are doing work where it is difficult to have lots of liability, either because it’s non-dangerous (e.g., designing websites) or you can contractually exclude much liability, then you’re almost certainly better served spending $500-$1000 a year on errors and omissions-type insurance.

If you are doing work where you can cause damages (anything dealing with people’s bodies or repairs to dangerous items), you definitely need to start with insurance and then look at your remaining liability exposure.

What’s your loss exposure?

Finally, if you’re just not that well-off, then spending an extra $1000 of time and effort and money to protect miniscule net worth might just not be worth it. If you have a home with equity and savings and retirement accounts, then, after you get sufficient insurance you can re-address this sort of question.

Once you’re properly insured (since not being sufficiently insured is one route to evaporating the limited liability protection you’re trying to establish by forming an LLC or other entity in the first place), then you can start analyzing the right entity for your purposes. If you’re going to be a single person in the business, then an LLC is usually the right place to start and end.

If your situation is different than the plain-vanilla model I described, then you should contact a lawyer with specific corporate experience. Your CPA doesn’t regularly address these issues of entity selection and may likely focus too much on the tax aspects, which is the wrong way to approach the issue (particularly since it’s easy to get the tax treatment you want these days with various entity types). Tax issues get addressed before you finally decide on an entity type.

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Since I’m a New York lawyer, I happened to notice someone in NY asking about LLCs:

With specific respect to NY LLCs, there is a publishing requirement that is just a pain in the neck, and so I recommend using a service to do the actual filings and publications. That is different from having them draft the actual LLC operating agreement, and any decent services would allow you to provide them with your own operating agreement. If you choose to do that piece yourself (again, only really a good idea if it’s just you in this business), then Nolo provides well-written guides.

How much do founders get diluted through exit?

This isn’t a new question.I regularly answered it for founders, employees, and even angel investors during my time at Brobeck in Silicon Valley. There are lots of people concerned about “dilution” without really knowing what it is.

Dilution means owning less of the whole than you did before some event, typically an equity financing in this context: what this means is that, as several answers hinted, the infusion of cash into the company in exchange for equity results in the issuance of additional shares. A founder (or similarly situated party) now has the same number of shares divided by a larger number of total shares on a fully diluted basis; the lower percentage total signals the dilution.

However, that is less than half the story. The real issue, the one that founders should care about (other than the quasi-mystical point at which they cross below 50.1%), is whether they have been economically diluted. If equity is sold at an increased valuation to that at the time shares were acquired, the new financing dilutes your % of the shares at the same time as the value of what you have has increased. You are better off financially as compared to the past, and on a present-tense basis, you are at least break-even.

Short example:

• 100 shares owned by Fran Founder. Fran owns 100%; value of company is $100; value of Fran’s stake is $100.
• Investment of $100 by Ivan Investor. Pre-money valuation is still $100, so share price =$1  => 100 new shares issued.
• Post-money: total shares, 200. Post-money valuation, $200 ($100 pre-money + $100 cash). Value per share, $1.
• Fran Founder holds 100 shares worth a total of $100 that represent 50% of the company.
• Ivan Investor holds 100 shares worth a total of $100 that represent 50% of the company.

This is dilution in the real world. Fran has a smaller percentage of a more valuable company, and measured at the moment of the financing, she has suffered no economic loss at all. Indeed, many would argue that the better-financed post-money entity is probably worth more than just the pre-money plus the cash, since the cash reduces risk and increases the likelihood that the company will achieve its business plan goals.

The purpose of this long segue is to help founders focus on the important issue, which is increasing the value of their companies. That, far more than worrying about percentage ownership, will enhance the value of what they own. One might write this off as the party line, a conspiracy concocted by VCs to ensnare founders and “steal” their companies. My evidence to the contrary is the fact that in the articles and certificates of incorporation that contain the terms of the preferred stock in which VCs invest, you will find nothing that addresses the ownership stake directly. You will, however, find antidilution provisions that are explicitly limited to economic dilution, i.e., the issuance of certain shares of stock below the price paid by an investor. The plain language tells me that VCs care about economic dilution and not about ownership dilution (as long as the economics are in line).

On the other hand, this article, from October 1, makes it clear that bank loans to businesses are actually up from last year while interbank lending is in fact down by ~12%. Interestingly, that 12% is about a tiny fraction of the amount of commercial loans, and the increase in commercial loans alone, over $200 billion, from last year is 3x bigger than the total amount of interbank loans.

Now, I don’t purport to know whether the interbank number is so critical to the economy. I do know that when I start looking for problems, I start with the biggest numbers. In this case, the commercial loan portfolio is about $1.5 trillion, vs. $72 billion for interbank. Where would you look first to see what’s going on? A source of change chart would be much more useful to put the issue in perspective — unfortunately, I don’t have time to put that together just yet. Maybe the Forbes.com editorial board will solve the dilemma for us.