Bridge Financings: Raising Money Between Equity Rounds

In this market, many startups are extending their runway until the next equity round by raising “bridge financing” between rounds in the form of SAFEs or convertible notes. SAFEs and convertible notes are standard documents, so the deal should be simple, right? If the next round is imminent or ongoing, the answer is “yes”: the parties can often agree to a no cap/no (or very small) discount SAFE. If the next round is further out, it gets complicated.

Most standard SAFEs and notes were designed to be used before a priced equity round, and many of the terms don’t align with parties’ intentions between rounds.

Let’s get into it.

Part 1 — The Valuation Cap

The concept of a valuation cap is out of its element after a priced equity round. The cap allows an investor in a SAFE or note to convert at the lower of the valuation cap or the valuation of the next priced equity round. Let’s say the Series A was at a $50M valuation, a SAFE round after the A had an $80M cap, and then (possibly due to a rough patch or market change) the Series B came in at a $70M valuation — the SAFEs would convert at the lower $70M valuation.¹ Notice that the SAFE investor doesn’t take any risk that the startup’s value may go down from the closing of the SAFE investment to the closing of the next priced equity round.

The cap makes sense for early stage companies where the future is less certain, especially if the investors (friends and family, wealthy individuals, etc.) aren’t pros at valuing startups. The pre-seed/seed stage angel investor relies on the diligence and sophistication of a later institutional investor to more appropriately determine the valuation in a priced equity round.

Once a startup has raised a priced equity round, however, later stage, more sophisticated, investors purchase equity with a fixed valuation, not a valuation cap. Sophisticated equity investors take the risk that the valuation of the startup may go down in the future. To mitigate a small portion of that risk, preferred stock investors usually receive what is referred to as “weighted average anti-dilution protection”, which basically means partial down round price protection proportional to the size of the new round. Weighted average anti-dilution protection brings the Series A investors to where they would have been had the Series B been a flat round (same price per share as the Series A), not to allow the Series A to get the full benefit of the price drop. It’s worth noting that this down round price adjustment is usually waived — it provides no benefit to the new B investors and dilutes management (and B investors want management to be sufficiently incentivized).²

So, what can you do?

1. Simply sell more A shares at a higher price: This usually captures the intent of the parties, and the only big downside is that it requires more documentation and time. Relatedly, each time you want to raise more than intended or increase the valuation, you need to amend the investment documents.
2. If there is going to be a valuation cap, also include a valuation floor: This offers the investor much greater protection than a fixed valuation, without removing the investor’s downside valuation risk entirely.
3. Replace the valuation cap with a fixed valuation and offer weighted average price protection: While perfectly reasonable because this mirrors both the pricing and the weighted average price protection of the existing equity investors, this is a relatively exotic solution that may offend the sensibilities of the “use a standard SAFE” investor.

Here is where your VC Board designees (in addition to any independent directors) can add significant value. Their existing equity investments only get partial down round protection, so existing VC investors are mostly aligned with management on pushing back against the full down round protection from a SAFE/note valuation cap.

If you end up agreeing to a valuation cap on a SAFE or note after a priced equity round, it may be worth it (the cap may far exceed the last round valuation), but you should go into the deal realizing the benefit of using a standard SAFE or note cap comes with this trade-off.

Special thanks to Jeremy Raphael for his insights.

Part 2 — The Discount

Part 3 — Timing

Part 4 — Exits and Convertible Note Nuances (Maturity and Interest)

Footnotes:

(1) Pre vs. post-money valuations are ignored for simplicity.

(2) Here is an example of weighted average anti-dilution — let’s say the Series A investors paid $8 per share of stock, the Series B was a down round at $4 per share, and the Series B investors were buying 20% of the company. Rather than the Series A investors getting full down round protection (what is referred to as “full ratchet anti-dilution”) and being repriced at $4 per share, they generally get weighted average anti-dilution protection, so their shares benefit from 20% of the price decrease (the portion of the company being purchased by the B), or, in this case, $8 — ($8 — $4) * 20% = $7.20. This differs from the technical calculations for simplicity, but the end result is the same. This also ignores the circularity of the A price decrease (more A shares) decreasing the B price, and so on.