Using venture debt - preventing a bridge round

Ideally, as a startup grows its funding will take it to milestones that allow for more equity to come in a higher prices (what are called up-rounds). Often those up-rounds are funded by a new, or outside, investor. Raising capital from an outside investor involves a competitive process which means that the market sets the pricing and terms.

Bringing in an outside investor gives the company comfort that the market is showing what is objectively a reasonable deal. Knowing this is important for the board, management and founders.

Sometimes, though, the cash doesn't last until that next round. This could be because of a delay in product development, a quarter or two of soft bookings or even a change in direction. Whatever the reason, if the company can’t fund itself to that next round its choices aren't great.

The outside investors may need to see progress to a milestone before funding. Or they may be willing to fund earlier but at a steep discount to what they would have paid had the milestone been met.

The current, or inside, investors are then faced with taking a lower price from an outside investor or funding the round themselves.

One solution to this problem is to extend the prior round. The inside investors might like this option, especially if company has progressed since the last round and they can buy stock at that old price. Although it can be done quickly, management and founders might not be so fond of this option because they will feel that the company has progressed and is worth more than it was at that last round.

Another possible solution is the bridge round. With the bridge round, the insiders invest through a form of convertible note. This note will convert into the next round at a discount to that round’s share price and typically comes with some warrants and/or an interest coupon. The bridge round has advantages in that it can be done quickly without the full road show and diligence of an outside equity round and it pushes the pricing question out until the full equity round. Sounds a bit like a venture debt round, doesn’t it?

But the bridge round also has some disadvantages.

The combination of discount into a future round and interest/warrants can make the bridge round expensive. Since outside investors don’t lead a bridge round, the current investors are left to set the terms and the board/management/founders are price takers. If I were a founder looking to price check a bridge round I would talk to other founders and some lawyers who work with startups to get a range of market terms.

The bridge round is a form of borrowing against the next equity raise. If current investors advance a $2mm bridge against a $7mm planned raise it means the raise will only bring in $5mm of new cash.

The largest disadvantage of a bridge round is the potential signalling it sends to new investors. Companies are typically funded with enough cash to reach the next fundraising milestone. A bridge round is typically a sign that the company did not hit its targets in the time planned. This could be a yellow flag for a new investor possibly resulting in a pause or a lower valuation.

A venture loan can be a favourable option compared to a bridge round:

·       There is no signalling risk; new outside investors don’t typically see a venture debt loan as a bad sign, particularly if it was raised close to the prior equity round.

·       The venture loan can fund a company to the next financing round while freeing up the full amount of equity to be raised fresh at the round rather than prior.

·       The loan does not set valuation which allows the founders/management to benefit from the higher valuation they want at the new round.

Company tip:

If looking at a venture debt round to help prevent an inside bridge be sure to model the cash flows. You want to ensure that the loan gives you enough capital to help you make it to your equity round in a reasonable downside case.

- Craig.