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.

You may or may not get a formal list from the other side, depending on their level of formality and the nature of their advisors. Some investors know exactly what they are looking for and will figure out what they want to do from your financial model and a series of conversations. Others assume that the only way to be sure is to review a mountain of paperwork. The real answer lies somewhere in-between for most companies.

So, to get you started or at least calm you, here is a super Short Form Due Diligence Request List for a seed round investment or low-key quasi-acquisition, such as an asset purchase or stealth acquisition.

First, keep in mind that the other party may, and probably will, ask for additional information. Our goal here is first to identify anything that might concern them so it can be defused or resolved before it’s ever disclosed. (Hint to bad lawyers: you cannot hide things; there’s always a second copy floating around; the goal is to solve the problem so you can disclose how it has already been fixed.) Our second goal is to streamline as much of your work as possible so that you are not under time pressure later. The third goal is to identify the factual support for the business plan/budget that will be a critical piece of the transaction.

Here is the list of other materials you should be gathering in the background as negotiations continue, documents are drafted, and the deal moves forward.

1. Financials — Copies of all historical financials for existing operations: Income Statement, Balance Sheet, and Cashflow statements. (A backup version of a QB file is something that I regularly work with to extract these directly if necessary.)
2. Material contracts — all contracts that are either above a specified dollar value ($10-25k) or are otherwise important to the continued operations of the business on a similar basis. This should usually include customer contracts, all leases, all promissory notes, and IP licenses, and anything to do with stock or securities (like a warrant agreement or agreement to trade stock for services of a consultant).
3. Corporate documents — Copies of current articles/certificate of incorporation & bylaws; minute book with board/shareholder consents & minutes.
4. Other risks — A description of any pending litigation, whether company is plaintiff or defendant; any audit letters from auditors if financials have been audited in last 3 years; a description of any off-balance sheet obligations or other liabilities; and a summary of any related-party transactions, individually or in the aggregate greater than $25,000.

This ThoughtStorm Due Diligence Request list is a version written from the perspective of an investor and is a little more detailed than what I have above. It’s more like a reasonably thorough list that will get you most of the way to complete for an early-stage company.

I guess I’ll be citing this decision to people who dismiss Scalia and Thomas as right-wing conservatives. It sounds like they have taken a principled approach to applying the laws of the land and accepted a result that might otherwise be objectionable.

Our federal system makes tradeoffs that were readjusted in 1787 after the Articles of Confederation proved a poor framework. Two follow-on shifts occurred after the Civil War and during the Civil Rights era, but the second of those was not a structural change to the system but a tweaking of where we draw bright lines inside the gray borders between state and federal domains.

I sense that there could be great lessons in here for mindless conservatives who call themselves federalists or states’ rights folks only because they think they can get the rules they want, and perhaps great examples for mindless liberals who do not want to believe that they are only looking for the rules they want too. These mindless _____’s are more alike than different, and they are equally dangerous to our collective freedoms — freedom from ___, and freedom to ____.

“[T]o secure these rights, Governments are instituted among Men, deriving their just powers from the consent of the governed.” Declaration of Independence.

The way that I look at these groups, which I lump together, and others who operate from a different mindset from those although toward the same ends, is that the distinction is between rules-based and outcome-based politics. This being a democracy and all, and with the fundamental protections built into our federal and state constitutions, I see myself as a systems guy, with a belief that if our systems are well-constituted, and continually subject to improvement, we should be able to consistently improve our actual results over time, with fewer disruptions from political shifts of relatively minor proportion to the grand scheme.

In such a system, it is entirely possible that we could, as a society, legitimately come to different conclusions about how we would operate in nearly every sector of public life, from the expansion or restriction of government as a participant in the economy, whether by intervention, regulation, or participation, to the relative expectations about how widespread and uniform any regulation should be (which is another way of talking about the state-federal balance).

My theory is that the contradictory view of modern “liberals” on the federal government as both king-like protector and despotic villain are grounded in the combination of Watergate, Vietnam, and the Civil Rights movement. In those three seminal interactions with the baby boomers, many saw the worst and best of the federal government all at once. (And to be clear, many people who call themselves conservatives have a similar fear of government.)

At the same time, modern “conservatives” have latched on to different memes, showing the potential tyranny of the central government and the entrepreneurial spirit of a vigorous federal system, a laboratory of 50 regulatory approaches that could lead us all to finding more efficient ways of regulating ourselves to maximize freedoms and wealth while minimizing dislocation costs, crime, and negative externalities.

I confess that I have never thought about specific elements of our history that are likely to be responsible for (or at least ideologically connected to), this description of “conservatives.” Perhaps World War II and Roosevelt’s court-packing plan, the Slaughterhouse cases, and similar depression-era changes are the genesis, but I seldom hear these types of people talk about these events. Maybe it is the failings of other governments, where tyranny has taken hold, that is the real example this group keeps learning from.

What events/movements provide the touchstones for this rule-based group? Do you think that there are inherent benefits to rules-based or outcome-based politics?

“What is a reverse merger or reverse IPO?”

Short answer: “reverse merger” is almost always spelled S-C-A-M.

There are a small handful of legitimate reasons why a non-scammy, non-scuzzy company would go through this process. It is expensive, provides little intrinsic value to the private company paying for everything, and does little else of note.

How is it structured?

Standard format: a private company enters into an agreement to merge with an existing listed (meaning on a stock exchange) company that has little or no assets, may have (preferably) gone through a bankruptcy to become a “clean shell,” and has existing stockholders whose shares probably have a fair market value of close to zero. These zombie companies may nevertheless have a stock price because of random trades, but the FMV is still close to zero. (You can do the math yourself, or just trust me.)

The merger goes through and the private company is merged into the public company with new shares issued to old private shareholders. The private company is thereby able to “take over” the securities filing status of the public company, meaning the private company is now effectively public (as if that matters!). In exchange, the shareholders of the shell get some amount of money, generally well into 6 figures (most of which will certainly go to fees for third-party advisors) and some percentage in the post-deal company (5-20% is not uncommon).

Why do people do these deals?

Because they think that now they can easily “raise money” that they couldn’t previously. Sort of true technically, but false on a practical level. Or, even worse, they think that because they’ve gone public, it magically comes with some kind of new capital. A full-form securities registration (S1) is expensive, and those companies still need brokers to sell the shares to investors. If you don’t spend the cash on the reverse merger, you could just look for underwriters to sell the shares in a regular IPO. Same result, cheaper, faster (since you don’t have to do the merger deal first), and without the equity haircut.

Are there legitimate reasons to do these deals if you’re the private company? Sure, there’s at least one: if you have an investor IN HAND who has ALREADY committed to investing but is subject to investment policy restrictions such as only investing in public companies, then the speed of getting from A to B via reverse merger might make sense. And in that scenario, the terms should be negotiated way, way down from the “typical” deal.

Bottom line?

In general, stay away and get advice from a reputable, experienced corporate/securities lawyer who has done mainstream deals before getting into this one.

Have any of you actually done one of these deals that made sense before or after? My suspicion is that it’s a null set. #FAIL

This one gets a #FAIL from me.

Hearkening back (or forward, since I don’t know if I’ve posted it yet) to my thoughts on why I write, one of them is definitely to signal to founders and directors of small and startup companies when they need to call a lawyer. I guess I’ll have to follow up soon with my hot-button post.

I think that it’s really useful for me to tell people when they absolutely need my advice (taking investment money of any kind), when I can almost certainly help (non-standard commercial contracts), when I can add value (helping negotiate a deal), and when I’m not helpful (picking colors for the website design). Honesty from me makes my clients more efficient, and I hope that it s’s more evidence to them and the not-yet clients that I fit their definition of “trusted.”

Here’s a recent Above the Law post on a job that really doesn’t appear all that worthwhile, really.

This is a downgrade from the $12 job they link to at the bottom of the post, but it’s a step up from the California job FOR AN ADMITTED ATTORNEY that paid so little it violated minimum wage laws.

Wowza. I suppose my economist friend would say this tells us something about the shape of the demand curve, right? But what, exactly?

Is this a supply problem, of there actually being too many lawyers, or is it a matter of there being such a demand for work that is legal in nature but doesn’t merit paying high costs for that work? In other words, there are lots of clients out there who aren’t Fortune 500 companies and are stretching for

Separate from the inherent interest in the notion that the pack may be far more powerful than the cigarette (and I like both Why We Buy and Call of the Mall by Paco Underhill as modest introductions to some of these ideas) is the question that doesn’t occur to the author but matters a lot to us here.

Could the federal government impose similar restrictions on cigarette manufacturers in the US? We know some labeling requirements are permitted (the Surgeon General’s warning), but what about the rest? Is the design of the package constitutionally protected speech? What “message” is there, or is the “expression” enough?

I’m not a commercial speech guru, but I’m sure some of you are: what’s the story on limits on packaging regulation, and has it changed because of Citizens United?

And for the non-lawyers, would requiring bland packaging be an acceptable compromise to (1) allow smokers to continue smoking, i.e., not outlawing them entirely, (2) reduce uptake by new consumers, i.e., people who are now our children, and (3) allow adults the opportunity to make bad decisions? And if we can tax the price of a pack as much as we want (and do), why not do this too, or instead? After all, if we’re not going to outlaw cigarettes, what can we do that works to reduce smoking?

To me, “crowd” is just the plural of “open,” as in open data.

But crowd doesn’t always work, and crowd doesn’t always scale (or, as I’ll discuss here, not in the right way).

Since Kickstarter got a lot of press as a way to make “projects” start moving with seemingly free or no-strings or on-my-own-terms money, people have been asking me about extending this to startups as a [pre-]replacement for venture capital and angel investment, both of which are seemingly harder to come by and once again slower in the bust than in the boom.

First off, we need to get a quick leader’s reconnaissance in, a lay of the land so that we’re all talking about the same thing. This is particularly important when it comes to “raising money,” which in startup-land usually means one very particularized thing, namely the sale of securities by an issuer to investors in an unregistered offering. Yes, I know I should have turned on the “legalese” tag for that sentence, but this is one area where you can’t fool around and paraphrase, or worse yet, euphemize.

Selling stock, warrants, options, and convertible notes to investors is generally always the sale of securities. Borrowing money through traditional promissory notes can be the sale of securities. The sale of securities is regulated up, down, and sideways by the federal government in the form of the SEC (and its regular partner, the DOJ) and by the states through the state attorneys general.

Take this lesson to heart:

1. Sale of securities  = highly regulated

2. Highly regulated => do yourself and your lawyer a favor and call before agreeing to do anything.

Securities law is one area of the law where even lawyers get lawyers. This is not DIY.

Your working model for securities should go like this: sales of securities require lots of expensive formal paperwork unless my lawyer tells me we have an exemption. Exemptions are available for most traditional venture investments (VCs are accredited investors and so are most real angel investors). Getting $1000 each from your cousins is generally not okay. Asking everyone you know or putting “raising series A” in your email sig are outright bad. These last two are examples of what the SEC may readily describe as a “public offering.” Public Offering, when it’s part of IPO, has a nice ring to it. When it’s part of your seed or series A round, it’s definitely flat.

Public offerings always require lots of expensive paperwork because that’s how you get to sell shares to everyone who wants them: the disclosure in the prospectus, written in “plain English” to comply with voluminous SEC regulations, is considered enough to allow a reasonable investor to evaluate the wisdom of buying stock from the company.

Crowdfunding, IF YOU MEAN selling securities to people through a nice public website with lots of visitors, is a problem. It’s almost certainly a public offering and will create big problems for you, the kind of problems that can easily kill a real venture financing.

Actually, Kickstarter itself doesn’t allow “investment and loan solicitations.” IndieGoGo, another site, is “not offering equity investments.” (I think it’s good that these sites are keeping people out of trouble.)

Advanced Masterclass Tip: you could conceivably use this method to sell securities only to foreign investors, but it’s probably not worth the trouble of trying to make the required restrictions fit into a site that’s designed to show everything to everyone. You’d be better off looking for some sort of angel investment opportunity site — which would at least be more likely to keep you out of inadvertent trouble.

NEXT: Crowdfunding a startup: what does work?

Post or email your questions on crowdfunding, and if they’re not already planned in the next post, I’ll work them in.

Are any of your intrigued by soliciting an investment in yourself, paying back with a portion of your earnings? The FAQ page is, sadly, empty; questions abound that the “template” contract doesn’t answer.

The idea is to give readers an informed opinion that, while not specific to their situation, highlights some of the major issues involved in various decisions, such as whether to form an LLC or corporation for your tech startup. (Hint: read this first.)

What is free advice all about?

To some, these posts look like free advice, which makes no sense for a lawyer who gets paid for giving advice. But that’s only half-right at most. From the lawyer’s perspective, only specific advice is worthwhile — after all, you can learn lots of general stuff about incorporation, venture financing documents, and even (although rarely) about venture math from lawyers, VCs, and entrepreneurs (who are now VCs).

What I tell prospective clients is this: you need advice that is competent, focused, reliable, and dedicated. These other writers all fall short on one or more of these factors, and even my own posts have the fault, necessary though it may be, of not being specific to *your* exact situation. Even something as otherwise “standard” as the Delaware C-corp will not apply to certain tech startups depending on the business model, the resources available to the founders, and even the actual nature of the underlying business. Could I lay out some examples here? Sure, but even then you wouldn’t necessarily be sure that your situation fell within the general guidelines. And you wouldn’t know whether there is some other fact in your situation that would change everything, like a substantial spendthrift trust for your living expenses. Trust me: no VC is worried about that issue from your perspective.

If I can’t ever get “real” advice, am I wasting my time?

So why do I write if I’m ultimately doomed to fail by my own standards? Well, first, I think there’s no harm in having high standards. Second, my real goal isn’t, and can’t be, to give you THE answer. Third, what I can do is tell you most of the questions, point you to many of the factors, and most importantly, show you how I approach the issues and structure my advice.

Because what you need, what you come to me for, is trusted advice. I show you that I’m trustworthy by showing (not telling) you that I know what I’m talking about and by giving you lots of evidence of my mindset so that you can see what sort of service, experience, and advice you’re getting.

And that makes a difference for different types of work: putting a typical venture deal together requires a classic Silicon Valley approach: focus on the high payoff terms, put everything else within the zone of reason, and get the parties moving forward; on the other hand, negotiating debt with strict operating covenants and a *gulp* personal guarantee requires a classic New York City approach: no stone unturned, every phrase — representation, covenant, and condition — examined and pushed in your direction.

Please share any examples of when you got the “wrong” type of lawyer for work you needed. What do you expect from a lawyer — what’s just the price of admission and what closes the deal?

Here’s another LinkedIn-derived question that merits a better answer.

The question was essentially whether the fellow with some IP to build a business on should form an LLC or a corporation. In typical LinkedIn fashion, off-the-cuff answers that are specific end up being wrong. In my mind, if someone is asking this question, they either want a quick answer without worrying too much about whether it’s the right answer, in which case they might as well just phone a friend, or they want to understand *how* to make the decision.

As my readers have probably learned by now, I’m happy to educate clients on how to make decisions, on what factors to balance, and point them in the right direction on perceived issues that are just red herrings. At the end of the day, we all have to make our own decisions. Even if you decide to defer to a lawyer to make this sort of call, even if that lawyer is me, then you’ve decided to adopt (if only by proxy) my view of the world and my evidence to you that I understand your goals and plans well enough to make a recommendation that is right for you, just you, in your exact situation at this exact time and place. That’s what I do and how I do it.

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Dan, the answer to that question isn’t usually determined by just how you’ll exit but also who you may need (or want) as Investors and their requirements, the amount of capital your business plan requires, the timeline between here and there, and what the company will look like as it’s operating (the activities it undertakes, the risks it creates, the nature of the competition, and the underlying business model).

The business model is basically how you take capital from Investors, convert it into revenue and gross margin, and do those things at an SG&A level that leads to the generation of free cash flow.

So, in a nutshell, that’s the start of the analysis that I and other startup lawyers do when advising entrepreneurs. Not everyone belongs in a Delaware C-corp even though almost all Silicon Valley-style tech startups do.

I’ve linked two articles that will round this out a bit for you.
Good luck!

Links:

• Incorporate a tech startup
• Compare ownership structures