What is a security interest in connection with a convertible note?
May 9, 2007
A security agreement creates a security interest in certain company assets. This allows the investor to take certain actions upon non-payment of the loan. The investor (or a collateral agent acting for the investors) may take possession of and sell the collateral and apply the proceeds to the repay the debt. If the proceeds of the sale exceed the amount of the debt, the company is entitled to the excess.
In order for the rights of the investor to become enforceable against third parties with respect to the collateral, the holder must “perfect” the security interest. Perfection is typically achieved by filing a document called a UCC financing statement with the secretary of state where the corporation is located. The investor will not be able to enforce its rights in the collateral against third parties, such as other creditors who claim a security interest in the same collateral or a trustee in bankruptcy, without “perfecting” the security interest.
Security interests are rare in seed stage convertible note bridge financings and not particularly common in bridge loans for venture backed companies, unless the loan is particularly risky, such as in connection with a bridge to a sale of company when the company is running out of money.
What does subordination mean in a convertible bridge note?
May 8, 2007
In the event of default, creditors with subordinated debt don’t get paid until after holders of senior debt are paid in full. Startup companies may ask holders of convertible bridge notes to subordinate their debt to existing and future senior debt from banks and other lenders. (Of course, most seed stage startup companies are unlikely to be credit worthy enough for this type of debt, so subordination provisions may be irrelevant for many startups.) Subordination provisions provide the company with the flexibility to incur senior debt without going back to the holders of notes for consent. However, many banks will request that their own form of subordination agreement be signed by holders of notes instead of relying upon the subordination provisions contained in a typical convertible note. A subordinated convertible note will define types of senior indebtedness and sometimes will place a cap on the maximum amount of senior indebtedness that may be incurred by a company.
Traditionally, equipment leasing facilities and equipment loan facilities, which are secured solely by the equipment financed, are not treated as senior indebtedness (nor are they typically subordinated to other forms of a company’s indebtedness). However in certain circumstances, this type of financing may be deemed to be senior indebtedness (i.e., if secured by a blanket lien).
Can you have multiple closings in a convertible note bridge financing?
May 4, 2007
Of course. Depending on the situation, additional closings can continue to be held for up to a fixed period of time (such as 30, 60, 90, 120, 180 days or even one year) after the first closing or anytime at the discretion of the board of directors. If there are additional closings, please keep in mind that (1) interest calculations on each note will be different depending on the closing date, (2) the notes probably should have the same maturity date despite being issued on different dates, and (3) if the conversion discount or warrant coverage is fixed, investors in a later closing might incur less risk than the earlier investors and perhaps the conversion discount or warrant coverage needs to be adjusted to reflect the difference in risk.
What should the terms of bridge loan warrant coverage be?
May 3, 2007
1. Type of shares
Typically, the warrant is exercisable for the type of securities issued in the next round of financing. If the company has completed a Series A financing and the bridge loan is a “bridge” to the Series B, then the warrant is exercisable for Series B when the Series B financing is completed. Savvy investors will negotiate a fallback mechanism where the warrant is exercisable for an existing security (such as common or Series A) if the maturity date is reached or if there is a sale of company before the next round of financing.
2. Number of shares/warrant coverage
The number of shares issuable upon exercise of the warrant issued in connection with the convertible note is referred to as “warrant coverage.” Warrant coverage is expressed as a percentage of the principal amount of the note. Calculation of the number of shares based on the warrant coverage percentage typically means:
[number of shares issuable upon exercise of warrant] = [principal amount of loan] * [warrant coverage percentage] / [exercise price per share in the next round of financing]
So 20% warrant coverage on a $500,000 bridge loan assuming that the next round price is $2.00/share would be:
[50,000 shares] = [$500,000] * [0.20] / [$2.00]
The amount of warrant coverage seems to mimic the conversion discount range of 20% to 40%, although higher warrant coverage is not particularly unusual. The amount of warrant coverage is tied to the amount of risk that the investor incurs. Warrant coverage and conversion discounts are mechanisms to compensate the investor for risk.
3. Exercise price
The exercise price of the warrant is typically the price per share in the next round of financing. Sometimes, the exercise price may be fixed at the last round price or some other pre-determined price, especially if the warrant is exercisable for the type of security issued in the previous round or common stock.
4. Term
Most warrants can be exercised for a period of 3 to 7 years from closing of the bridge financing. 5 years is probably common.
5. Termination upon sale of company or IPO
Warrants should expire on a sale of company and probably should expire on an IPO. However, the holder of the warrant will have the ability to exercise the warrant immediately prior to these events. Warrants should expire on a sale of company because acquirors do not want to assume warrants and generally demand that warrants be exercised prior to closing. Although acquirors are willing to assume employee options in a sale of company, holders of warrants typically do not have any relationship with the company after the closing of the sale transaction. Many companies prefer to have warrants expire on an IPO to eliminate the share overhang associated with the warrants.
What should the maturity date of the convertible note be?
May 2, 2007
The maturity date probably should be related to the amount of time that the money will last or the anticipated date of the event to which the funds were meant to “bridge.” The term “bridge” indicates that the loan is supposed to last until a specific event, like an equity financing or liquidity event. VCs seem to cringe at bridge loans that are a “bridge to nowhere.” As a practical matter, most companies will not have the funds to repay the loan at maturity, so the investors will generally continue to extend the maturity date instead of plunging the company into bankruptcy or taking other drastic actions.
Most bridge loans have maturity dates of less than one year. Many early stage seed bridge loans seem to have relatively long maturity dates, such as six months to a year. To satisfy the requirements of obtaining an exemption from the licensing requirements of the California Finance Lenders law, the maturity date of the bridge loan may be no longer than one year. A longer bridge loan makes the exemption unavailable, but does not necessarily subject the lender to the licensing requirements.
What happens if the company is sold after the convertible bridge note is issued and before the maturity date or the next round of financing?
May 1, 2007
Sometimes the convertible note is silent on this point, which would mean that the investor might simply get repaid the principal amount of the note plus interest upon a sale of company. I think that investors generally should have the right to receive a return greater than simple interest upon a sale of company before the next round of financing.
Savvy investors will negotiate for one of the following (1) a fixed or floating rate of return greater than simple interest (either similar to the conversion discount or something like 1.2x to 2x the principal amount), or (2) the ability to convert the debt into common stock or preferred stock at some pre-determined price (in order to capture the “equity upside” in the sale). There are some tricky tax issues for investors with regard to the concept of original issue discount, which I will leave for a later post.
I think it is generally unfair for a company to prepay the note without the consent of the investors in this situation, because this might eliminate the “upside” potential of the investors.
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