Most startups think of a convertible note as the most common fundraising vehicle used during the pre-seed and seed stages (see related article titled “Convertible Note Basics“). What they might not know is that convertible notes are also used for what’s called a “bridge round”. It is just like it sounds, bridging the gap between today and some point in the future. This article describes the use of convertible notes for such a scenario and, more specifically, the differences and nuances versus using them for seed rounds.
For those not already highly familiar with how convertible securities work, click the book cover image to read chapter 5 from my bestselling book on fundraising called Startup Success – Funding the Early Stages of Your Venture. The free chapter provides a full primer on convertible securities, including a comparison between the SAFE and convertible notes. Click here to order the book.
The Importance of Timing
Bridge rounds are quite common and there’s a reason. Timing is everything in fundraising. Well, actually timing and outcomes are everything in fundraising, but they go together (see related article titled “Investors Write Checks for Outcomes, Not Activities“). The more time you have the more interesting outcomes you can both accomplish and flaunt to ensure a successful funding round at a desirable valuation. In my article titled “How Much Should You Raise?“, I introduced the following graphic to describe the interrelationship between money raised, time/resources, outcomes and valuation. The abbreviated flow goes like this:
- The Amount raised yields both Time and Resources in which to accomplish interesting Outcomes
- The State of Your Business (current and projected future Outcomes) influence the Valuation
- The Amount raised compared to the Valuation determines the dilution existing equity holders will experience
A bridge round is specifically pursued to buy more time and there are only two scenarios driving the situation:
You Need Extra Time
In this situation, you either aren’t able to close a funding round before running out of cash or don’t want to because the terms (ie – valuation) will be bad enough that you’d rather raise some new money to get extra time. In both cases, you need extra time to accomplish things to improve your odds of fundraising success.You Want Extra Time
Even if you can raise money at decent terms, there are situations in which a little extra time can improve your hand even further. Just be careful here because forgoing an “OK” funding round in hopes of a better one could backfire. Your trends could go sideways or you could lose an important customer, strategic partner or co-founder. The economy could go into a tailspin or some other factor could cause the venture funding markets to dry up. You get the idea. As the old proverb says, “a bird in the hand is worth two in the bush”.
How much extra time do you need? That all depends on the additional outcomes you think you can accomplish and how long, realistically, it should take. I say “realistically” because things usually take longer than expected, so take that into consideration when estimating.
Here is a specific scenario and perhaps a way to think about it. Assume you raised your seed round at a $6M valuation and 12 months has now gone by. During that time, you had to pivot the business slightly and lost an important co-founder that was later replaced. As a result, you didn’t achieve all that you wanted/needed and now find yourself with only 3 months of cash runway left. You recently tested the fundraising appetite with your existing investors and some new ones but anticipate only reaching an $8M valuation. That’s not very interesting to you and your co-founders since you’re plan is to raise $5-6M and the dilution hit would be big.
Interestingly, there are two significant things you feel can be accomplished in the next three months with fairly high certainty. One is a new strategic partnership that will give significant credibility and revenue leverage. The other is a new customer acquisition method that is already showing hope for cutting your average sales cycle and customer acquisition cost (CAC) in half (see related article titled “Visualizing the Interaction Between CAC, Churn and LTV“).
- Side comment: Other examples of interesting accomplishments that could be on the near-term horizon include a new product line extension that will carry twice the price tag, a new bad-ass executive you’ve been courting and is now hinting she is ready to join the company, and your most recent cohorts of new customers are showing significantly better operational metrics (ie – time to value, engagement, conversion to paid, etc).
Let’s imagine three scenarios that could result from the extra time and associated accomplishments:
- $10M valuation – somewhat interesting
- $12M valuation – more interesting
- $15M valuation – definitely attractive
Now all you have to do is look into the crystal ball and predict how likely the accomplishments are and also the valuation-driving effect they will have. Easy, right? For sure not, but that’s why you’re getting paid the big bucks to make such decisions. Seriously, this is why fundraising is equal parts art, science and luck. It is actually very unlikely that the range of valuation outcomes could be so great ($8M to $15M) just from an extra three months of runway but I decided to use this example to make sure the trade-offs are clear. Every situation varies.
Using a Convertible Note for Your Bridge Round
Maybe by now the benefits of using a convertible note are obvious.
- You aren’t forced to set a valuation
- Existing and newly-interested investors can get favorable terms compared to the expected Series A (via the discount you’re offering)
- Legal costs and associated efforts are fairly minimal
But since this is a short-term bridge round intended to just buy you a little time, there are typically some differences in terms compared to using a convertible note for a seed round. Specifically:
Term
The term is short. In fact, if the note doesn’t have a short term then it doesn’t support the messaging of this being a bridge round. 6 months of extra runway is common and anything close to 1 year starts to smell like a regular funding round and not a bridge. Why not just ask for 3 months of extra runway since that’s what you predict you’ll need? Well, that really puts the pressure on you to deliver and leaves no margin for error. Plus, your Series A will likely take 3 months or more to close from start (first official pitch) to finish (close).
Discount
With such a short term, bridge notes commonly have lower discounts than when they’re used for seed funding rounds. In other words, 10-15% discount is common versus 20-25%. Similarly, you might offer the investors a low discount if you are able to reach a qualifying transaction in 3 months (ie – 10%) while increasing it (ie – 15-20%) if it takes longer than that.
Valuation Cap
It’s actually possible to not have a cap in a bridge note, especially if you fit into the “want extra time” category as described above instead of “need extra time”. Remember, the valuation cap is intended to offer the investor a high-side valuation protection mechanism (see related article titled “Justifying the Valuation Cap in Your Note“). With a short term like 6 months, the odds are very low that you’re going to suddenly and surprisingly grow like a rocket ship. If you like this idea of not having a valuation cap, consider a 15% discount instead of 10% to ensure the investor feels rewarded for helping you get the wanted/needed extra time.
Forecasting the Future Cap Table
I have a mantra that recommends entrepreneurs optimize for growth, not dilution. However, because of the various scenarios that might cause the valuation cap to come into play, I do recommend using a cap table calculator to run various scenarios and forecast what the cap table and various equity positions would look like after the convertible notes convert to equity. You can find a link to one on my Resources Page.
What About Using a SAFE?
A “cousin” of a convertible note is the Simple Agreement for Future Equity (SAFE), created and promoted by Y Combinator (see related article titled “Reviewing the SAFE Investment Instrument“). In a fundamental sense, I don’t see why a SAFE couldn’t be used for a bridge round.
The biggest issue I see is the lack of a term, and it’s the short term on a convertible note that helps demonstrate that it’s truly being used as a short-term or specific-duration bridge to the next round. Since SAFEs don’t have the concept of a term, I have a harder time associating them with a bridge round. The exception might be when a SAFE was used for the prior round and the existing investors represent a meaningful percentage of the expected investment in the bridge round. Sticking with the same instrument (ie – SAFE) could easily make sense.