What is the California Finance Lenders Law?
June 26, 2008
Under the California Finance Lenders Law (the “CFLL”), a person engaged “in the business of a finance lender or broker” within California generally must obtain a license from the California Department of Corporations. The law provides a number of exemptions from this requirement, including exemptions available for small business investment companies and persons that limit their lending activities to no more than one loan in any 12-month period.
However, the licensing requirements of the CFLL are not triggered by a qualified bridge loan (”QBL”), which is defined as a “commercial bridge loan” made by a “venture capital company” to an “operating company.” Thus, a venture capital fund that made only QBLs would not be required to obtain a license under the CFLL. However, a fund that makes other types of loans should be subject to licensing requirements only if those loans cause the fund to be engaged in the business of a finance lender or broker.
In general, a “commercial bridge loan” is any loan that:
1. Has a principal amount of $5,000 or more;
2. The proceeds of which are intended to be used by the borrower other than for personal, family or household purposes;
3. Matures in one year or less;
4. Is made in connection with, or in contemplation of, an equity investment in the borrower;
5. Is secured, if at all, solely by the borrower’s business assets (but not by real property); and
6. Is subject to the implied covenant of good faith and fair dealing arising under Section 1655 of the California Civil Code.
A venture capital fund generally will be a “venture capital company” if it:
1. Engages primarily in the business of promoting economic, business, or industrial development through “venture capital investments” or the provision of financial or management assistance to operating companies;
2. At all times maintains at least 50 percent of its assets in venture capital investments or commitments to make venture capital investments;
3. Maintains or, assuming consummation of the equity investment to which a commercial bridge loan relates, will maintain a material equity interest in the borrower;
4. Approves each loan made to an operating company through the fund’s board of directors, executive committee, or similar policy body, based on a reasonable belief that the loan is appropriate for the operating company after reasonable inquiry concerning the operating company’s financing objectives and financial situation; and
5. Complies, when making the loan, with all applicable federal and state securities laws.
A ”venture capital investment” is “an acquisition of securities in an operating company that a person, an investment adviser of the person, or an affiliated person of either, has or obtains management rights to.” The statute provides no definition of the term “management rights,” but the term is well defined in other places. The first is the definition of “venture capital operating company” under the Employee Retirement Income Security Act of 1974 (”ERISA”). The second is Rule 260.204.9 of the California Code of Regulations, which deals with the regulation of investment advisors.
In general, a borrower is an “operating company” if it:
1. Engages (directly or through subsidiaries) in the production or sale, or the research or development, of a product or service other than the management or investment of capital;
2. Uses all of the bridge loan proceeds for the operations of its business; and
3. Approves the bridge loan through its board of directors, executive committee, or similar policy board, based on a reasonable belief that the loan is appropriate for the borrower after reasonable inquiry concerning the borrower’s financing objectives and financial situation.
What is the economic difference between a conversion discount and warrant coverage for a convertible note?
June 22, 2007
The advantages of a conversion discount versus warrant coverage depend on math and modeling.
In the example of 20% conversion discount versus 25% warrant coverage, the formulas below apply.
The value of investment with the 20% conversion discount = {[Investment amount] / [0.8 * Series A price]} * [exit value of Series A]
In other words, the above formula represents: how many shares of Series A do you get after the discount * the exit value of Series A per share.
The value of the investment with 25% warrant coverage = {[Investment amount / Series A price] * [0.25] * [exit value of Series A - Series A warrant exercise price]} + {[Investment amount / Series A price] * [exit value of Series A]}
In other words, the above formula represents: the exit value of the Series A warrant shares (taking into account the warrant exercise price) + the exit value of the Series A shares issued upon conversion of the note.
If Series A price (and Series A warrant exercise price) = $1.00, then the 20% conversion discount will always be slightly more valuable than 25% warrant coverage. (This is simple algebra to solve for the above equation.)
There is a reason why I think corporate attorneys need strong math skills. I hope someone will check the above math and concur or correct me.
Who pays legal fees in a convertible note bridge financing and how much does it cost?
May 13, 2007
In deals where investors don’t have counsel, the term sheet usually says that each party will bear its own legal fees and expenses. It wouldn’t be unusual for investors to not engage counsel in an early stage convertible note financing with friends and family. If one of the investors wants to have the documents reviewed by counsel, those fees typically are paid by the company, which is customary in any VC financing. The amount of fees to investor counsel can be as low as $2500 for a quick look at documents and no due diligence in a seed stage deal, to over $15K, depending on the amount of diligence and the complexity of the documents. Investor’s counsel may conduct UCC searches and extensive due diligence, especially if the note is secured. In complex deals, investor’s counsel fees may exceed $50K to $100K. Investor counsel fees payable by the company are typically capped, with the investors responsible for any excess over the cap.
Company counsel fees could be under $10K if there is no negotiation on terms and a single investor to over $30K if there is extensive due diligence and complexity. Company counsel fees on convertible loans may exceed $100K for later stage companies or extremely complicated deals. Company counsel fees are higher than investor’s counsel fees because company counsel drafts documents (on the West Coast) and needs to solve diligence issues. In addition, there is typically some deferred corporate housekeeping that needs to be done by company counsel before the financing.
Why should a majority of investors be able to amend the convertible notes?
May 11, 2007
In the event a company needs to amend or waive a provision in the notes, absent a provision that says that the note can be amended or waived with the consent of holders of a majority in interest of the notes, the company has to get every single investor to agree to the amendment or waiver. This ends up being difficult as a practical matter if certain investors are unavailable or refuse to sign an amendment or waiver. Typical situations where a company may want to amend or waive a provision of the note might include extension of the maturity date, changing the terms of the automatic conversion on a qualified equity financing, etc. Majority is measured by the principal amount of the notes. The majority trigger may be set higher to two-thirds or seventy-five percent depending on the situation.
What should the representation and warranties in the note purchase agreement be?
May 10, 2007
Some investors are perfectly willing to purchase notes without receiving particularly extensive representations and warranties from the company. Other investors want the same level of detailed representations and warranties as a typical VC Series A financing. Generally, I think that if there is a bridge loan after a Series A financing, the investors should receive the same level of representations and warranties that the previous Series A investors received. This means that the company probably needs to prepare a detailed schedule of exceptions or disclosure schedule to disclose things required by the representations and warranties. Representations and warranties in seed stage bridge financings generally will be less extensive than in VC Series A financings, which probably reflects the fact that representations and warranties for an early stage company are not necessarily meaningful because there is very little to disclose. In addition, as a practical matter, the recourse for a breach of representations and warranties generally is a claim against the company for damages. Making a claim for damages against an early stage company without any money may be futile.
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.
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