What is a convertible bridge note with a price cap?
January 11, 2010
I seem to be doing a lot of pre-Series A convertible bridge note financings these days. As I have written previously, I think that convertible notes with even large conversion price discounts (e.g. 50%) or warrant coverage are typically more company-favorable than a Series A financing where a valuation is set. After completing a lot of convertible debt deals over the last year on behalf of both companies and investors, I have refined some of my thoughts about pre-Series A convertible debt terms.
Observation 1 — Convertible debt is a bad deal for angel investors
I think many sophisticated angel investors realize that convertible bridge notes do not adequately compensate angel investors for the risk that they take in funding early-stage companies. For example, typical provisions in a company-friendly pre-Series A convertible bridge note financing may include a 20% conversion discount from the Series A price and a 2x return on a sale of company.
Assume the angel investor invests $500K. If the company eventually raises $50M in a Series A financing at a $100M valuation, a 20% discount from that price is not particularly attractive compensation for that investment risk, as the investor would only own about 0.4% of the company after the financing (assuming that the shares issued upon conversion of the bridge were not included in the pre-money fully-diluted share number). Similarly, if the company is sold for $100M, the investor would only receive 2x their investment back (plus interest), or a total of $1M, which would only be 1% of the sale price.
If the investor had invested $500K in a Series A Preferred Stock at a $4.5M premoney valuation, then the investor would own 10% of the company. If the company raises $50M in a Series B financing at a $100M valuation, the investor would own 6.67% of the company post-Series B financing.
Similarly, if the company was sold for $100M before another round of financing, the investor would receive 10%, or $10M.
Observation 2 – Angel investors realize convertible debt is a bad deal so they demand price protection provisions (i.e. a price cap)
Due to the economic results described above, many sophisticated angel investors refuse to do convertible note bridge financings unless the conversion price on the debt is capped. In other words, an investor may request that the conversion price is the lower of (i) a 20% discount from the Series A price, or (ii) the price per share determined if the valuation was $[X]M. Typically, the valuation might be some reasonable projection of the valuation range in the eventual Series A financing. The valuation is typically higher than what would be set if the investor and the company negotiated a valuation at the time of the convertible debt financing, but lower that the expected Series A valuation if the company achieved their objectives.
Similarly, in the event of a sale of company before a Series A financing, a sophisticated angel investor may request that they receive the better of (i) 2x their investment back (plus interest), or (ii) the return if they had invested their money at an $[X]M valuation.
In any event, I think that convertible debt financings are still easier to complete than a Series A financing, so a convertible note with a cap achieves the investor’s objective without the complexity of a Series A financing.