February 11, 2008

Two thing to keep in mind when structuring your bridge financing

Filed under: Start-up First Aid — Administrator @ 5:16 pm

(1) DISCOUNT, PLEASE! Keep the structure simple and offer your bridge investors a discount to Series A Preferred share price rather than a warrant:

A real quick way to lose investors’ interest is to price your bridge financing at the same multiple as Series A Preferred shareholders are paying. In lieu of a discount what we’re seeing from start-ups (particularly, those with American legal counsel) is a warrant granting the right to purchase shares COMMON SHARES at the same valuation as Series A

Yeah, are we like…missing something here? Bueller?…Bueller?..

Common folks, time for a quick reality check. If you’re coming to us, looking for bridge financing, offering a note that converts into Series A Preferred shares, why on earth would we have any interest in exercising a warrant for common shares at the same price as the more valuable preferred shares?

Furthermore, why would we have any interest in acquiring additional common shares when preferred were still on offer – it is like walking in an Aston Martin dealership packed to the gills with inventory, buying an Aston Martin DB9 and as a bonus being given a coupon to buy a Chery QQ for the same price as the Aston Martin.

Look, bridge rounds are highly attractive and potentially lucrative deals to roll into, yet a bridge investor undertakes a relatively higher level of risk and uncertainty than a Series A investor; thus the bridge note must absolutely positively reflect this risk. And a discount to Series A is the simplest and cleanest way to accomplish this.


(2) ODD LOTS? Avoid irrevocable super majority rights and odd lots holding the same rights and warranties as your Series A Preferred investor(s):

So, your next door neighbor, Xiao MeiMei, and her extended family want to dump the equivalent of US$32,000 into your bridge round. Word gets out that you’re looking for cash and quickly snakes through the hutong. Next thing you know you have 23 different bridge loan commitments from various “friends & family” totaling the equivalent of US$411,000. You’re rich…rich…rich! Great news, right?!

Well, not really…because in the bridge subscription documents (lovingly prepared by your brilliant lawyers for US$40,000) excluded language that makes the distinction between rights and warranties held by institutional investors and those held by Xiao MeiMei, mom, and pop.

We could go on about this but we’ve already turned this blog into the Mahabharata – so, let’s cut to the chase – we have two words for you – super majority.

In the past, we’ve advocated (fiercely) that a founder, when faced with a funding situation that will massively dilute their equity holding, should seek some protection in the form of super majority rights. But, this is definitely not the case when you’re structuring bridge financing. Doing so leaves yourself (and company) exposed to the possibility that handful of bridge investors (e.g. those investors that are two or three degrees removed from your real “friends & family”) that could block or challenge future business related decisions with a flick of their pen.

How might this be possible?! Well, one scenario would be a situation where an institutional investor (e.g. venture capitalist) subscribes to the bridge and pulls down 40% of the entire offering. The venture capitalist, cognisant of the fact that once the bridge loan converts into Series A Preferred shares (and given the significant number of mom and pop odd lot bridge co-investors and the ensuing dilution from larger Series A investors), will neither have control of the equity class (Series A Preferred) nor (in some cases) a board seat (as this seat may have to be relinquished the larger Series A investors or there is only one board seat available to all bridge investors); and thus in order to ensure rights and interests are protected may insist upon the inclusion of clauses granting super majority rights in the Series A shareholder’s agreement.

What a headache this becomes for the company when faced with business critical decisions (requiring preferred shareholder approval) because now, not only will you need to chase down with your 20 plus odd lots, bridge institutional investor, and Series A investors but also you’ve got to build consensus across an investor base that is as diversified as New York City in the summertime. (Job Posting: ISO cat herder or rodeo clown with excellent communication and taser skills).

Alternatively, you could face an issue where the lead investor in Series A, as part of closing conditions, insists that super majority rights get revoked. So, do you go with the big money and dook it out with those investors who’ve supported you when no one else would or do you walk away from the money (knowing full well you might encounter the same push back from other investors)?! Hopefully, you won’t be under the gun to make such a decision as the sound of the last dollar from your bridge round is hovered from your corporate account.

So, do yourself a favour – when structuring bridge financing: (1) avoid irrevocable super majority clauses; and (2) if you’re not in the position to turn away odd lots from your bridge round, either give them common shares (preferred path) or get them to sign a side letter transferring control of their preferred rights to management (messy, but effective).

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