Clean Sheets

A quick rule of thumb to help keep your bridge financing from hurting your next equity round

Belgian keeper Thibaut Courtois won the award for best goalie in the 2018 FIFA World Cup and recorded the most “clean sheets” in the English Premier League last season

Venture capitalists typically prefer uncomplicated deals. Anything unusual can be used as an excuse to move on to another deal. The hottest financings are exempt from this guideline, but in general, entrepreneurs are safest when keeping their companies, term sheets, and capitalization tables “clean” of complexity. The simpler the situation, the more likely that investors will focus on the merits of the team, the market, and the opportunity.

This is the context in which I tend to provide advice when asked whether it is better to raise a bridge financing first, prior to raising the next equity round. Even though bridges (also known as convertible debt) are common, my answer is usually, “if you can avoid it, don’t raise a bridge, because it is ‘cleaner’ just to raise your round.”

In most cases, if your inside investors want to participate in the round, it’s better just to “soft-circle” their commitment and communicate that number to a new, outside lead investor, and then raise a priced round instead of a bridge. But there are a few situations where a bridge can make sense:

  • If the transaction cost — specifically the legal bill for a preferred stock financing — is not justified by the proceeds (this is most often the case when you first start your company and the initial funds raised are small in comparison to the legal bill)
  • If you are out of money and haven’t achieved milestones needed to entice new investors, but your inside investors still believe in the company and are willing to give you more time
  • If you have potential new lead investors that have expressed interest but are trying to squeeze you on valuation, and your insiders want to give you the support to negotiate from a position of strength (an inside round may be a better solution in these situations)
  • If your lead investor can’t close for a structural reason, but everyone else in the syndicate is ready to fund you, and you are ready to accelerate the business (this sometimes happens when a venture capital firm is in the process of closing a new fund, for example)
  • If you are worried that your inside investors are interested now, but something might change for them during the next few months while you finish securing a new, outside lead (if you are aware of something that might be a “material adverse change” to your own business, the ethical thing to do would be to alert your inside investors)

But let’s assume you are in a scenario when a bridge makes sense. The next question is how much to raise in the bridge, and a good rule of thumb is to raise no more than 25% of the total planned round.

Why? When a new investor is trying to price a round, the easiest math requires answering only two questions: 1) How much do I want to invest? and 2) How much does our fund need to own?

The answer to the first question is usually dictated by the needs of the startup, and new investors rarely make it to the term sheet stage if there is a significant mismatch between the typical check size of the investor and the size of the round being raised.

To answer the second question, most investors try to project what kind of multiple can be generated, but they will also refer back to their fund strategy. Many investors target specific ownership percentages and may have communicated these numbers to their limited partner investors (again, all bets are off for “hot deals”). It’s not uncommon for VCs to represent that they target ownership percentages of 10% or 20% of a company. In my experience, 20% has been a magic number for many professional VC firms over the past several decades. This number represents enough of a minority ownership percentage that suggests the investor will probably be taken seriously once the investment closes, so 20% isn’t just an arbitrary figure. And many VCs want more than 20% ownership for a meaningful commitment of capital.

If many VCs want to own 20%, why could a bridge of more than 25% of the total round pose a potential problem?

Let’s say the planned round is $10 million, and you want to raise a bridge of $5 million to jump start the process. This leaves no more than $5 million available for your new lead investor. Remember, they might want 20% or more of the company. So $5 million buys 20%, which means $10 million would buy 40%. Except you probably are giving a discount to your bridge investors, or putting a cap on the valuation. Maybe you will give a 10–20% discount to your bridge investors (Fenwick & West lists terms for bridge financings in its 2017/2018 survey of market trends). Depending on how the discount is calculated, your bridge investors’ ownership could be worth up to 31% of the company. Add that to the 20% purchased by the new investors, and now the round provides 51% ownership to investors.

51% is much more than most entrepreneurs want to give up in any one round (leaving aside the change of control triggers that may create additional problems like a “deemed liquidation”), and the new investor might not like it either. Most VCs want to make sure that entrepreneurs are sufficiently motivated to stay focused on the business, and venture capital is generally designed as a minority equity investment mechanism. So when VCs who want to own 20%+ see a relatively large bridge and do the math, they realize that either they will own too little, or the entrepreneur will own too little, and they often pass on the deal because the situation is too complicated.

In contrast, if you are raising $10 million and have already closed on a bridge of $2.5 million, you have much more flexibility. If you find a lead investor that believes the company is worth it, you can sell 20% for $7.5 million, and even after providing a discount of 10–20% for your bridge investors, you aren’t going to give up more than 30% of the company. Or you can raise a slightly smaller round. Maybe the new investor still wants 20% for $5 million, as in the original example. You could always stop the round at $7.5 million, and you still will limit dilution to less than 35%. If you keep your bridge under 25% of your total planned raise, you probably have more options.

As you engage with investors, it’s a fair to ask whether or not the firm maintains an explicit target ownership percentage. As an aside, corporate venture capital (“CVC”) firms potentially provide an exception to the math described above. CVCs, especially those that are public companies, sometimes prefer to remain below 20% ownership for accounting reasons, and a startup’s commercial relationship with a corporate investor may provide both parties with the confidence that the CVC has a “seat at the table” even if its ownership position is smaller than 20%.

Unless you know you are targeting investors who don’t need to own 20% or more, it can be helpful to keep your bridge under 25% of the total planned raise. Just remember, a bridge financing is yet another variable for investors to consider, and VCs can get headaches from complicated equations. Complexity is a distraction, so keep it simple, whenever you can.

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Scott Lenet is President of Touchdown Ventures, a Registered Investment Adviser that provides “Venture Capital as a Service” to help corporations launch and manage their investment programs.

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