Browse > Home / Convertible note / What is a convertible bridge note with a price cap?

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.

Written by Yokum · Filed Under Convertible note 

Comments

  • Jimmy
    I am looking into something similar to this arrangement and investment vehicle for funding my start-up. How do I go about structuring that?
  • @Jimmy - Go hire a startup attorney to advise you.
  • Gyro
    Yokum,
    Is it possible to offer a Convertible Note that has a cap that moves with the amount raised?
    (i.e. - I would like to raise $50k-$100k for about 10% of the company, so the cap on the pre-money would move from $450k to $900k).
    Also, the number of investors is uncertain.
    How could one construct a Convertible Note to achieve this?
    Thanks,
  • @Gyro - That's just a drafting issue. I don't understand why this is a defensible position from an analytical basis, however.
  • Jay
    Understand insight of the blog, but perhaps you can please correct why my calculation provides a different result:

    - $500K @ 20% discount = $625K effective conversion
    - $625K / $100M post-money valuation = 0.6% ownership for initial investor [believe this is complicit w/ your assumption that the shares convert @ the time of the investment - not included in pre-money]

    Understand 0.6% very low, but how did you get 0.4%?

    thanks!
  • @Jay - post-money = $150,625,000. $625,000 / $150,625,000 = about 0.4%
  • Jay
    Thanks!
    Is it usual case that convertible raise is not considered part of the pre-money valuation when the Series A investor invests, or varies based on particular investor?
  • @Jay - Depends on the facts. If the funds from the convertible debt have been fully used, then it probably means that the valuation of the company increased. In that case, the shares issuable upon conversion of the convertible debt should probably be in the pre-money valuation.
  • A very valuable post, Yokum. Agreed that convertible notes are usually a bad idea for the angels. I wrote a post about that a few years ago: http://www.angelblog.net/Convertible_Note.html.

    I like your idea on the cap.

    More interestingly, I just posted a video from the last Bellingham Angel education event where Dan Rosen, Chair of the Alliance of Angels in Seattle, suggests that a reason that lawyers often recommend convertible notes is because of the fees. Dan suggests that most lawyers know companies doing angel deals haven't been able to afford the fees for a preferred share agreement.

    Here's the link to the video - please let me know what you think - http://www.angelblog.net/Angel_Term_Sheet_Evolu...
blog comments powered by Disqus