I focused in my last post about breaking up M&A transactions into stages, where a potential acquirer can start by purchasing a minority interest in a company, followed by a purchase of the remainder of the company later. The same approach of breaking a transaction up into bite-sized pieces can be taken with investments that are never intended to be full acquisitions of a company. Equity financing transactions can be structured as a multi-stage process, e.g., an investor purchases a 10% interest and then is obligated to purchase another 10% in the future if the company hits a certain milestone.
But I wanted to focus here on the very common “bridge loan” transaction. The scenario here is that the company wants to (or needs to) put off a significant financing transaction for some period of time – perhaps because it has to develop its business in some manner that would be required to attract the investment – but it needs temporary funds to allow it to do that developing. Rather than negotiating a full-fledged VC-style equity investment, the solution is to structure a bridge investment as a convertible note. The note will automatically convert into equity when the company completes its equity offering over a threshold amount. A selective list of issues to think about in structuring the bridge loan transaction:
- The bridge investor will typically demand a discount on the conversion as a reward for early investment, e.g., when the debt is converted to equity, a 20% discount will be applied to the purchase price being paid by the equity investor used to calculate the conversion ratio. From the company’s perspective, you don’t want to provide too much of a discount, which could dampen the enthusiasm of the equity investor to participate.
- The investor will often require a pledge of assets to secure the payment of the note. Of course, everyone’s aim is to bridge to a financing, after which the pledge can be released, but the company should be aware if it pledges its assets that it is effectively betting the company on the ability to complete the equity financing before the note matures.
- The investor will also require interest to be paid on the bridge note. From the company’s perspective, the ideal structure would be to require no ongoing payments of interest, but rather the interest accrues and is itself convertible into equity upon the closing of the larger offering.