2016 is the year of the bridge round

This is a co-post written by my coworker Erin Shipley and I.

The first month of 2016 has set a distinctive tone in the startup community: it seems like we’re looking at a year of relative pullback ahead. I’ve already seen the belts tightening among my fellow investors; it finally feels like last year’s predictions of the boom/bust chatter are starting to come to fruition. What I’ve seen most clearly is a sharp change in the kind of traction and metrics VCs are expecting from companies looking to raise new rounds.

This is going to catch many companies off guard.

The term “bridge round” is often taboo for people in my profession. We try to talk around it, using names like “seed extension,” or “acceleration round” as if the terminology makes a difference. The truth is that bridge rounds happen, and they happen more during perceived economic downturns, when the balance of power shifts from entrepreneurs to investors.

It’s not that bridge rounds are necessarily bad, but they can raise difficult questions about whether or not it actually makes sense to continue to fund a company. As an existing investor, it can be hugely helpful to have a framework to evaluate these rounds, especially since they will be more common in 2016.

With that in mind, Erin and I came up with a quick checklist to help our fellow investors frame their thoughts when it comes to bridge rounds.

The first — and most important — question you have to ask yourself is whether you still believe in the company.

· They might be 1–2 quarters behind, but if they execute on their plan, is there a vibrant market for their product? Is there clear technological differentiation? Can this eventually become a sizeable business?

· Is the core team you invested in still in place? Are they fatigued, or is there ‘flight risk’ among the broader team?

· Is there a logical pivot that the company is pursuing and that you support? Not every company is going to find product market fit at the early seed stage, and it’s estimated that it can take 2–3x longer than most founders think to find the right fit for scale.

Assuming you still have a strong conviction about the business, you can start to look at the quantitative and qualitative questions to consider:

To what extent will this bridge round improve the chances of you making a better return?

· How much do you think the company could be worth if it manages to execute on the plan?

o Say your estimate is $500M

· How much do you currently have in the deal?

o Say $250K

· How much do you need to put up in the bridge round

o Say $250K

· Conventional wisdom tells us that only about 10% of all startups succeed, and that the odds for companies at their earliest stages are weighted towards failure. We also know that between 2011–2014 the average Series A company has approximately a 28% chance of raising additional capital and an average Series B company has about a 35% chance of raising additional capital.

Taking this data and calculating the probabilities of success for companies at different stages, we can assume that about 5% of Seed funded companies succeed, and about 9.8% of Series A funded companies succeed (or at least grow to a stage with a possible likely exit).

So if the bridge capital provides the company with the resources it needs to get to a Series A fund raise, then the math you should do is:

Don’t Participate: $500M * ownership % * 5% — $250k

Participate: $500M * ownership % * 9.8% — $500k

By and large, this calculation will support participation — if the new investment amount isn’t substantially high, and the participation will more or less guarantee a Series A raise. (Just know that the second of these two assumptions is very hard to rely on!)

Does your participation enable the company to attract new investors?

There’s more to think about than just the math above. For instance, your decision not to participate can send a negative signal to potential new investors, who might be able help get the company to its series A as well as providing additional capital pools for future use.

These investors might also bring new connections and relationships that could be helpful to the company strategically. One analysis showed that seed companies with some VC backing were 62% more likely to raise a Series A round than seed companies with only angel/non-institutional funding.

Are you the most exposed investor?

Sometimes a company might require more than one bridge round, and you want to have the reserves to protect your position should you need to pony up money for a second — or make sure that you are equally exposed compared to the other investors.

For simplicity, imagine there are 2 funds in a deal. Your fund manages $10M and Fund B manages $50M. If you have to write a check for $100k, then fund B should be writing a check proportional to their ownership in the company or proportional to their fund size. If they are writing a check for <$100k, then something is really wrong.

A few more things to think about:

Make the mistake once, you might be forgiven. Make the mistake twice and you might be fired.

Investors in venture funds might excuse them for making one wrong bet — perhaps your investment thesis didn’t pan out, or there was a falling out among the founders. No investor has perfect foresight. When considering putting more money into a company as a bridge, though, there needs to be a robust investment thesis. Not being able to justify why you continued to plow money into a company that quickly fails indicates that you aren’t paying attention to the reality on the ground.

It’s okay to say no.

Investors should feel comfortable saying no to bridge rounds if they’ve spent the time going through likely outcomes and made an honest evaluation of what they believe the company’s future to be. Some firms have it as a rule that they don’t invest in bridge rounds at all!

And finally, if you do participate, make sure your new money is protected.

This is especially important if not every existing investor is participating in the bridge round. Make sure you’re very clear on the liquidation preference of your capital, and that any agreement you get into reflects the risk you are taking.