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.

Comments

  • http://www.angelblog.net basilpeters

    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

  • 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!

  • http://www.startupcompanylawyer.com Yokum

    @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?

  • http://www.startupcompanylawyer.com Yokum

    @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.

  • 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,

  • 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?

  • http://www.startupcompanylawyer.com Yokum

    @Gyro – That's just a drafting issue. I don't understand why this is a defensible position from an analytical basis, however.

  • http://www.startupcompanylawyer.com Yokum

    @Jimmy – Go hire a startup attorney to advise you.

  • Pingback: The Curious Case of the $150M Series A « Interest In Things

  • jay

    Follow-up ? please on the cap:

    Assume $4.5m cap on the 500k convertible debt note. Assume your example & assumptions (e.g., debt does not come out of pre-money, lesser share price of discount vs. cap).

    The calcs below to determine ownership post-series A are off by 0.3% – any thoughts ? :

    Seed investor = 10% (cap applied since $100m pre-money > $4.5m cap, so investor amount = 500k / 5m seed post-money valuation)

    Series A investor = 33.22% ($50m / $150.5m)

    Founder = 56.45% ( ($100m pre-money valuation – (10% * $150.5m)) / $150.5m )

    Total = 99.7% … appreciate any help !

  • http://terezan.tumblr.com/ Tereza

    Yokum — how do angels react to warrants instead of a cap?

  • http://www.startupcompanylawyer.com Yokum

    @Tereza – Angels would prefer a price cap as that is generally more beneficial to them than a conversion discount or warrant coverage.

  • Jay

    Hi Yokum,

    Our seed-stage convertible note term sheet includes a $4.5m cap, and if we are acquired prior to financing, the investor receives a 2x return on their invested dollars (the acquisition does not result in conversion to equity). All of our investors (a mix of angels & VCs) except 1 (an angel) agreed to the term sheet as-is. The 1 investor says wo/ this acquisition conversion clause the investors will not be aligned / incented to help us get acquired. Do you agree? We understand they would be more incented w/ a higher rate of return, but a 2x return w/in 1 year is also good / standard market rate. We were also thinking that if an acquisition came to fruition, we could at that time reward our investors w/ conversion to equity or a higher return in order to provide a further reward for their assistance / investment. Any thoughts are very appreciated…

    Thanks,
    Jay

  • http://www.startupcompanylawyer.com Yokum

    @Jay – Don't understand the question. If there is a $4.5M price cap on the Qualified Financing conversion, then I assume the change of control clause says that the investor gets the better of 2X return or what they would get if they converted at the $4.5M cap. This seems like a fair deal, although the $4.5M cap seems high. (If you could get investors to agree to a $4.5M cap, I suspect that the company is far enough along that you should just do a priced Series A financing.)

  • Jay

    Thanks.
    - Change in control clause simply specifies that investor receives the outstanding principal + unpaid accrued interest + a premium equal to the outstanding principal amount (effectively a 2x return on the investment).
    - hmm – prbly could have done a priced financing, but this is already in play now

  • Jay

    Hi Yokum,

    Do you ever see convertible note agreements where the acquisition clause uses a price higher or lower than the conversion cap?

    For example, convertible note w/ cap of $4m, but in case of acquisition the note converts at $6m valuation.

    Elements of rationale:
    - if acquisition happens quicky / wo/ much effort on part of investor they still receive good return on investment.
    - if believe acquisition is imminent, conversion cap should be higher in 1st place.

    thanks,
    Jay

  • http://www.startupcompanylawyer.com Yokum

    @Jay – I haven't seen anyone negotiate it that way. I suppose there's some rationale for it, but I've never had anyone try to argue for a different number.

  • Mike

    Yokum: Can you point me to a loan agreement, note or other document that contains standard provisions addressing the various components of convertible debt discussed in this very helpful post and comment thread? For example, language that defines conversion price discounts or anti-dilution protection.

    thanks,

    Mike

  • http://www.startupcompanylawyer.com Yokum

    @Mike – I don't think there is an open source convertible note set of documents out there.