Convertible bridge loans – look beyond the headline terms

image Convertible bridge loans are an investment instrument often used by startups, usually to raise a smaller amount of money ahead of a bigger round.  It is called a bridge loan because it bridges the company until the full funding round (or sometimes to another event, e.g. an exit).  It is called a ‘convertible’ because the intention is usually that it will ‘convert into the next round’, normally at a discount.

For example, company Acme Software might raise a £1m bridge round from existing investors designed to cover losses until they close their £5m Series B round which it is hoped will happen in the next three months.  The loan might convert into the Series B round at a 20% discount to the Series B share price.  The discount is designed to compensate the lender for the extra risk they are taking by investing in the company before it is properly funded.

To show the maths: if the share price in the Series B was £10 then the £5m Series B investment would get the investor 500,000 shares (5,000,000/10=500,000) but the lender’s discounted shares would be 20% cheaper at £8 a share and their £1m would buy 125,000 shares.  The total number of B Shares in issue would then be 625,000.

The two headline terms of convertible loans that most people focus on are the ones mentioned above – the amount of the loan and the discount to the next round at which it converts.

That is fine so long as everything goes to plan and the next round is closed, but the loan documentation also has to deal with what happens when there is no new investment round, lets call that Scenario B.  These additional terms are often neglected when the loan is initially discussed and agreed and they are also the ones that can cause the most problems.

Typically if there is no new investment round by an agreed date one of two things happens, either the loan converts into an existing class of shares at a pre-agreed price or it is repaid.  Most commonly, if there is no new round the loan converts into the previous round at the previous round price.  In the case of Acme Software that would have been the Series A and the loan investors would get the benefit of the Series A price of some time ago, despite the progress the company has presumably made since then.  This only works if the company has been going forward.  If the company hasn’t been moving forward then lenders often ask for a low share price conversion which gives them a big equity stake if the company isn’t successful in raising that next round.

With some bridge loans if there is no new round the documents stipulate that the company simply has to repay the money to the lenders, usually along with interest or a repayment multiple.  From the company perspective the thing to watch out for when negotiating the loan documents is the ability to repay, because if the they can’t then the lenders may well be in a position to take control of the company.  If the date at which repayment becomes due is a long time after the date at which the loan is granted it can be tempting to think that someone is bound to have invested in a new round by then or otherwise not give the scenario proper consideration.  That could be a big mistake.

This topic is on my mind because we have seen a number of cases recently where insufficient consideration has been given to the scenario B – where things don’t go to plan and there is no further round.  Nine times out of ten Scenario B works out better for the lender than the shareholders in the company, sometimes much, much better.

  • Two thoughts:

    1. I've thought of convertible bridge loans as a way for existing VCs to put money into an investment in anticipation of investment from new VCs which will help put some valuation on the table. This could be when there has been no valuation for a while or there has been a disruption – like 2008. The preponderance of these cases going into scenario B must be high, I suppose.

    2. Convertible bridge loans do tend to have interest/dividends as well. So that would mean money/shares in addition to the discount available when converting. Sounds like a good deal from a VCs perspective. Are these terms applied or do they tend to get waived off?

  • I thought about mentioning interest in the post, but in the end decided to keep it simple. You are right that interest often features – sometimes that is instead of a discount and sometimes in addition. This latter can get to be punitive on the company.

  • Hi Paul – you are right – most notes specify a valuation at which they convert if there is no round, so valuation should be discussed, and I agree that it is usually simpler to use equity. And I like simple ☺