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.

I’ve noticed some interesting posts on the subject by Brad Feld, Josh Kopelman, Jeff Clavier, Dick Costolo, and Education Revolution, among others. In addition, there seemed to be a lot commentary (such as from Fred Wilson) about Charles River Ventures QuickStart Program that involves a seed financing with a convertible note with an increasing (but capped) discount over time.

Generally speaking, I think that the founders of a startup company are probably better off with a convertible note financing over a Series A financing in a seed round for a couple of reasons.

1. A convertible note avoids setting a valuation for the company. In a seed Series A, the valuation is probably going to be fairly low and difficult to determine. Even if the convertible note converts into the eventual VC Series A at a discount (or also has warrant coverage), the amount of dilution suffered by the founder in the convertible note is less than the dilution suffered by setting the valuation low in the seed Series A. This assumes that the valuation at the time of the seed financing will increase at a rate greater than the discount/warrant coverage on the convertible note. People good at excel should try to model the different scenarios.  Venture Hacks has a good article about the math involved in this modeling exercise.

2. Convertible note documents are simpler than a Series A. This means that a convertible note financing should get closed quicker and cost less in legal fees than a Series A. However, this is not always the case.

That being said, I think that there are two principal reasons to dislike convertible debt from the founders’ perspective.

1. Convertible debt investors have a perverse incentive to want the valuation of the company in the eventual VC Series A to be low, so the investors and the VCs have a greater percentage ownership of the company compared to the founders after the VC Series A.

2.  Investors may request aggressive terms.  For example, investors may require the company to grant a security interest in all of the company’s assets, personal guarantees from the founders, drastic measures upon an event of default (i.e. the equivalent of getting your arms broken if you don’t repay), etc.  In a Series A financing, there seem to be some established norms on what is typical.  In a convertible note bridge financing, creative investors may suggest some unusual terms.

I will run through the nuts and bolts of a sample convertible note bridge financing term sheet in the next series of posts.