Yesterday I talked a friend through how bridge rounds work and what he should look out for. This is what I said.
A bridge round is generally for companies that have raised one round and want to wait a little longer than anticipated to raise their next round so they can get to a higher valuation. The bridge is usually provided by existing investors.
How it works
Bridge rounds are generally structured as loans that convert into shares when the company raises its next round. The next round is generally defined as a ‘Qualifying Event’ which stipulates that the round must be over a certain size and should come from someone who doesn’t have existing connections to the business. In this sense it is similar to the convertible notes that some startups use as a structure for their seed rounds.
Like convertible notes the bridge converts at a discount to the next round. Discounts typically range from 10-20%.
Things to watch out for
The first thing to watch out for is the size of the discount. This gets complicated in two ways.
- Discounts are sometimes combined with interest on the loan which has the effect of making the discount bigger. If you work the numbers through a 15% discount combined with a 10% interest rate on a loan that runs for six months is the same as a 19% discount with no interest.
- Investors sometimes ask for “Exploding discounts” that are fixed for a period of time and then increase every month after that. One example I saw recently was fixed at 15% for six months and then increased by 1% every month after that. From an entrepreneur’s perspective this structure can a) result in very large discounts over time (and remember that rounds sometimes take an awfully long time to pull together), and b) create a perverse incentive to close quickly which puts the company at a big disadvantage in negotiations.
The second thing to watch out for is what happens to the loan if the next round fails to materialise. Loans that become repayable after a period of time create huge risk because there may not be enough money to make the repayment. If this happens the investors that made the loan are in a position to demand almost anything from a company, including to convert into shares at a very low share price. In place of a repayment clause it is generally better to agree that if the loan isn’t repaid within a certain time period (commonly two years) then it converts into shares at a share price that is agreed now. That won’t be a high share price but it shouldn’t be too low either. The share price of the last round is a common choice. Remember that this is a downside scenario that should have a low probability of occurring.