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).

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.

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.

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.

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.

The company could either (1) pay back the loan (which is unlikely since it is probably out of money), (2) ask the investors to extend the maturity date, (3) convert the loan into the last round of Preferred Stock (if any) at a pre-determined (i.e. last round) price (or price negotiated at the maturity date), or (4) convert the loan into Common Stock at a pre-determined price (or price negotiated at the maturity date). If the company can’t repay the note, then the investors could push the company into bankruptcy.

The typical situation when the maturity date is reached is for the company to talk to its investors and make sure that they don’t do anything drastic, like declaring an “event of default” on the note.

If there is already a series of Preferred Stock outstanding, then allowing the investors to convert at their option into the Preferred Stock is a good alternative, especially if the conversion price is agreeable to both the company and the investors.  As a practical matter, I think it is tougher to pre-negotiate a conversion price into common stock.

Sometimes aggressive investors will ask to control the board of directors or other things upon a payment default.

Typically, the convertible note should automatically convert into Preferred Stock upon a “Qualified Financing.”  The “Qualified Financing” is usually defined as a financing raising a certain amount of money (including or excluding the amount of the convertible notes).

The size of the Qualified Financing is typically set high enough to make sure that the financing legitimately sets a valuation for the company.  A Qualified Financing set at a very low amount (such as $500,000) might be questionable at setting a valuation on which the conversion price is based.  A Qualified Financing is usually set at some amount the company would legitimately need to raise after hitting the milestones that the bridge financing provided.  I think that it probably should be at least $1 million of new investor money or greater.

Other tweaks to the definition of Qualified Financing may include limiting it to a financing involving a VC.

The conversion discount refers to the discount from the price per share price paid by investors in the VC Series A that is used to calculate the number of shares of Series A issued upon conversion of the note into Series A. The discount generally seems to range between 20% to 40% depending on the situation. I’ve recently completed an extremely early stage high risk deal where the discount was 50%.

If the conversion discount was 20% and the price of the VC Series A was $1.00 per share, then each $0.80 of note would convert into one share of Series A.

Charles River Ventures announced a QuickStart seed funding program where the conversion discount increased monthly, but capped at a maximum discount. In my opinion, this seems like a good deal for founders.

The purpose of the conversion discount is to give the investor an appropriate return for investing in the company before the VC Series A round.  The other way for the investor to receive an extra benefit is to receive warrant coverage.  In some situations where there is only a short time between the bridge loan and the Series A, no conversion discount and some amount of warrant coverage seems more appropriate.

The concept of the discount increasing over time seems to make sense to me. If a company only needs 2 months of bridge loan before a VC Series A, then the discount should be lower than a bridge loan that may be outstanding for 12 months. A bridge investor needs to be compensated for the potential valuation increase during the time period that the bridge loan is outstanding, plus compensation for risk. I think the amount of discount needs to factor in (i) the length of time until milestones or other metrics are achieved that would enable the VC Series A round, (ii) the length of time that the funds will last, and (iii) general risk.

Generally, the interest rate seems be somewhere between 7% to 10% per annum. Interest is typically paid at maturity. Most of the time, interest converts into preferred stock instead of being paid in cash. There are “usury” laws that limit the maximum interest rate unless an exemption is available.

California Usury Law provides that the maximum annual interest rate for non-consumer loan that may be received by a lender not exempted from its provisions is the higher of (a) 10% per annum, or (b) 5% per annum in the excess of the rate prevailing on advances by the Federal Reserve Bank of San Francisco to member banks on the 25th day of the month prior to the earlier of the (i) borrowing in question, or (ii) the date of a written commitment to make such loan.

There are certain exemptions available from California Usury Law including if (i) the indebtedness is at least $300,000 in original face amount or the indebtedness is issued pursuant to a bona fide written commitment for the lending to the issuer of at least $300,000 and the parties to the transaction meet certain other requirements, or (ii) the issuer of the indebtedness has total assets of at least $2,000,000 and the parties to the transaction meet certain other requirements.

A warrant issued in connection with the convertible bridge note or the conversion feature in the loan may render the interest rate potentially usurious unless an exemption applies.

CONVERTIBLE NOTE BRIDGE FINANCING

SUMMARY OF TERMS

____, 200_

Company: [___________], a [_______] corporation (the “Company”)

Amount of Financing: Up to $______________ may be issued.

Type of Security: [Secured][Subordinated] convertible notes (the “Notes”).

Purchase Price: Face value.

Interest Rate: Annual interest rate of [___], [payable at maturity][quarterly in arrears].

Convertibility: In the event the Company consummates, prior to the Maturity Date (as defined below) an equity financing pursuant to which it sells shares of its Series [ ] Preferred Stock (the “Series [__] Preferred Stock”) with an aggregate sales price of not less than $_____________, [including][excluding] any and all convertible bridge notes which are converted into preferred stock (including the Notes issued under the Note Purchase Agreement), and with the principal purpose of raising capital (a “Qualified Financing”), then the Note shall automatically convert all principal [and accrued interest] under the Note into the Series [ ] Preferred Stock at [___]% of the price paid by investors in the Qualified Financing. The Note shall convert into shares of Series [ ] Preferred Stock on the same other terms as the other investors purchasing Series [ ] Preferred Stock in the Qualified Financing.

If the Company does not consummate a Qualified Financing prior to ____, 200__, the Notes shall be convertible into common stock at a conversion price of $___ per share.

Term; Prepayment: The day that is [one year] following the date of the Note (the “Maturity Date”). All principal and accrued interest under the Note is due and payable on the Maturity Date. The Note may [be prepaid at any time without penalty upon five days prior written notice to the Holder][not be prepaid without the consent of the Holder]. [Any prepayment must be made in connection with the prepayment of all Notes issued under the Note Purchase Agreement.]

Payment on Liquidity Event: If a Liquidity Event occurs before repayment or conversion of the Note into equity, the Company will pay the holder of the Note an amount equal to _____% of the outstanding principal amount of the Note plus any accrued interest due under the Note upon the closing of such Liquidity Event. For purposes of this provision, a “Liquidity Event” shall mean (a) a merger of the Company with or into another entity (if after such merger the holders of a majority of the Company’s voting securities immediately prior to the transaction do not hold a majority of the voting securities of the successor entity), (b) a sale by the Company of all or substantially all of its assets or (c) the closing of the Company’s first firm commitment underwritten public offering of the Company’s common stock registered under the Securities Act of 1933, as amended.

Warrant Coverage: ________% coverage with warrants to purchase Series [ ] Preferred Stock at the Series [ ] Preferred Stock price per share, exercisable for [three (3) years] from the Closing of Financing. The right to exercise the Warrant shall terminate upon a Liquidity Event.

Closing: ________, 200__. A first closing will be held on or before _______, 2007 or such other date that the Company and the bridge investor(s) participating in such closing mutually decide upon. Additional closings may be held up to 90 days after the first closing at the option of the Company.

[Subordination: The Note shall be subordinated to all indebtedness of the Company to banks, commercial finance lenders, insurance companies, [leasing or equipment financing institutions] or other lending institutions regularly engaged in the business of lending money [(excluding venture capital, investment banking or similar institutions which sometimes engage in lending activities but which are primarily engaged in investments in equity securities)], which is for money borrowed, [or purchase or leasing of equipment in the case of lease or other equipment financing,] whether or not secured.]

[Security Interest: The Notes will be secured by all assets of the Company[, excluding intellectual property].

Note Purchase Agreement: The Notes will be [(i)] issued pursuant to a definitive Note Purchase Agreement containing customary covenants and representations and warranties of the Company [and (ii) secured pursuant to a Security Agreement].

Amendment: Holders of a majority in interest of the principal amount of the Notes may amend or waive any provision of the Notes and such amendment or waiver shall be binding on all holders of the Notes.

Expenses: The Company and the bridge investors will each bear their own legal and other expenses with respect to the transactions contemplated herein.