Convertible Debt Financing 101

One way that a startup can take seed or angel investments is by doing a convertible debt financing, sometimes called a bridge loan or bridge financing.  It is essentially a loan the company receives which allows the investor to later convert the amount due into a certain number of preferred shares upon the company’s next round of equity financing.

Generally, in one of these deals, the investor will put up money to receive a note and a warrant, which they buy through a note purchase agreement (these are the three documents used in the transaction – although there are other ways to do it).  The note acts as a loan document, the warrant allows for purchase/conversion into stock (preferred or common), and the purchase agreement contains the terms of the deal – which are negotiated – usually investors will want certain representations and warranties from the company – which are generally obligations and statements of things that exist at the time of investment.

The note will provide that the loan amount, plus interest at a set rate, is due an payable upon a certain maturity date (usually six months, but variable).  Its customary for all the interest to be paid at maturity and not prior to it.  Its important from the company’s perspective to have a round of equity financing prior to the maturity date, because if there is no more cash inflow, then the company will owe the full loan amount plus interest and will likely not have the cash to pay.  An frustrated investor can take control of a company and even force it into bankruptcy if there is no prospect of being repaid.

Assuming the company lines up an equity round of investment prior to the maturity date, the investor will be able to convert the amount owed by the company into equity to buy an amount of shares based on the price per share paid by the investors in the equity round, although the note holder gets a discount when buying the shares.  The investor will receive a conversion discount (usually 15 – 40 %), although they can also receive “warrant coverage” which is similar conceptually but the math is a bit different, which allows them to purchase stock for less than the price per share applicable in the current round of investment.

For example if a startup receives a bridge loan and gives a 20% discount (standard), then if the next financing round is at a $1.00 per share purchase price, the bridge investor will be able to purchase the shares for $.80 each. Warrant coverage is a bit different, and can be better for the investor or company, but it all depends on the next round investment price per share.  There are other complexities such as placing a cap on the future round of financing.  We’ll discuss the cap and warrant coverage in later posts.

Bridge loans work well in early stages of as startups life, because the company and the investor do not have to arrive at a valuation of the company when the do the financing.  It is delayed to be performed by the equity investors in the equity financing round.