Bridge Financings: Raising Money Between Equity Rounds — Part 4
SAFEs and convertible notes were designed to be used before a priced equity round, and many of the terms don’t align with parties’ intentions between rounds.
This is part 4 of a series walking through the right changes to make to SAFEs/notes to reflect the right economics between equity rounds.
See Part 1 — The Valuation Cap, Part 2 — The Discount, and Part 3 — Timing.
Part 4 — Exits and Convertible Note Nuances (Maturity and Interest)
Exits
What happens if the company is sold prior to the SAFEs/notes converting? If there is a valuation cap, it’s easy: the SAFE/note holder usually receives the greater of the original investment amount or what they would receive had they converted at the valuation cap. This is similar to a 1X non-participating liquidation preference on preferred stock, which is considered standard in most VC rounds, particularly Series Seed through Series C. In an exit, the 1X non-participating liquidation preference similarly allows the investor to choose between the greater of (i) 1X their investment, or (ii) what they would receive in the exit based on their ownership % of the company.
A long long time ago, convertible notes used to have exit multiples — the right to receive the greater of (i) more than 1X the original investment or (ii) what they would receive if they converted at the valuation cap. You don’t see those as often nowadays, and, assuming the existing preferred stock has a 1X non-participating liquidation preference, you generally shouldn’t agree to an exit multiple after a priced equity round.
If there’s no cap, investors in the standard discount-only SAFE simply get their money back. Some investors may ask for a fixed valuation or cap to address the risk the SAFEs/notes remain outstanding for longer than anticipated prior to the next equity round or exit, e.g., a fixed valuation or cap that kicks in if the SAFEs/notes have been outstanding longer than X months. If the parties can’t agree on this valuation, they may consider the straight line “discount” discussed in Part 3 (which could apply in an exit or priced equity round).
Note Maturity
This is only relevant for convertible notes because SAFEs don’t have maturities.
When a convertible note matures, the investor has the right to have their note principal plus accrued interest repaid in cash. Often the company has the right to “pay” the investor with equity in case the startup doesn’t have the money or the desire to pay off the note in cash. Having substantial convertible note amounts due in cash at maturity is risky, which is one of the main reasons most convertible rounds have switched from notes to SAFEs.
— What alternatives are available at note maturity to address this risk? —
If the notes have a valuation cap, then the startup will often push for the right at maturity to force conversion of the notes into equity at the valuation cap. If investors push back, then a compromise would be to allow the investors to choose between keeping the notes outstanding after maturity or converting into equity at the cap. Why would an investor agree to a company right to force conversion into equity? Simple — the whole point of the note is to convert to equity at the next priced equity round, meaning the investment is intended to act similarly to an equity investment, not a true loan. Investors in startups very rarely have redemption rights (rights to ask for their equity investment to be paid back), so it doesn’t follow that convertible note investors after a priced equity round would have a similar right.
Keep in mind that allowing investors to choose to leave their notes outstanding vs. converting to equity at maturity means that interest continues to accrue on the notes. While the investor accruing interest is arguably ‘off market’ for an equity-like investment (as discussed in greater detail below), it’s better than forcing the startup to repay the note at maturity. Of course, the lower the interest rate, the better …
Where these deals often get bogged down is when there is no valuation cap — in order for the company to force conversion, there needs to be a conversion valuation. Very often this only comes into play when things haven’t gone exactly according to plan, so the parties may consider negotiating more of a valuation “floor” solely in the case of maturity, presumably a valuation between the last equity round valuation and the valuation at the time of the convertible note investment.
You might be thinking, if the parties end up contemplating a forced conversion event upon maturity, why not just use SAFEs instead? You’re right — bridge rounds are increasingly structured as SAFEs to address this issue (among others).
Note Interest Rate
The note interest rate is an anomaly in startup investing. Accruing (or cumulative) dividends in a priced equity round is the economic analogue to accruing interest on a convertible note. Accruing dividends are amounts equal to a % of the investment that accrue from the investment date and usually are not paid until a liquidation event (e.g., sale of the company or IPO). Accruing dividends are exceptionally rare (especially before Series D) in venture capital deals, so why do convertible note investors receive accruing interest? The most direct answer is that notes are considered debt and debt must have an interest rate equal to at least the applicable federal rate (AFR) at the time of the note issuance. Of course, many investors will push for interest rates higher than AFR arguing that it’s “market”, but those arguments are generally bogus. If the investment were actually intended to be debt (which would usually be subordinated to any senior loan), the interest rate would be higher and there would be much lower or 0 equity upside.
Startups should push for interest rates as close as possible to AFR and for the option to pay accrued interest in cash instead of equity at conversion, especially if the next equity round is expected to occur in the next few months.
Special thanks to Jeremy Raphael for his insights.
