COVID-19 and Startups: The Case for Convertible Bridge Notes
It’s been an unsettling time for global financial markets. Covid-19 has created the uncertainty that was lacking in the bull market of the last 10 years. The result has been volatility in public company valuations rarely seen before, not to mention significant cash flow issues within multinational companies. Inevitably, the pandemic shock has also hatched financing problems for startup companies as capital markets grow increasingly competitive for fewer available dollars.
Startups rely on funding until they can generate sufficient revenues to operate. However, issuing a new round of preferred stock may not be feasible today because valuations and timing are more uncertain, leading investors to demand additional concessions. Further, a down round in these situations may trigger features for older investors, an outcome many would prefer to avoid.
For startups that need cash, the question becomes how to continue operations without locking the company or current investors into unfavorable terms. Convertible bridge notes, which allow investors to invest today to get into future rounds at a discount, can be a great solution. Before we explain why, let’s walk through some of the alternatives.
Traditional Funding Sources
A new round of preferred stock. This is the favored approach for early stage private companies. Buyers of preferred stock provide essential funding and are willing to take on the risks and lack of liquidity from private companies. That being said, market downturns can find these investors sitting on a smaller amount of capital for investment (what the industry calls “dry powder”) while they contemplate a larger number of opportunities. Beyond that, for a traditional investment they need to establish a good sense of what the company is worth and how and when they’ll be able to recoup their investment and profit. Finally, if the round is below past issuances, various down round protections may kick in, diluting investors without these protections.
An IPO. The company could take a stab at the public market, but this has several drawbacks:
- Price uncertainty is still an issue. The company will likely be locking in unfavorable pricing and triggering events for previous rounds of preferred financing.
- The IPO process is long and difficult. Even if the company has an existing relationship with an investment bank, requirements like disclosures, accounting processes, and underwriting agreements take time and money—two things the company doesn’t have right now.
- It’s expensive. The investment bank will take 4-7% just for assisting with the IPO, the company will need to update its internal infrastructure to match SEC requirements, and the incremental costs of being publicly traded are considerable. A PwC survey found 83% of CFOs estimate spending more than $1 million in one-time costs associated with the IPO, and two-thirds of CFOs surveyed estimate that being public costs $1-2 million annually.
The upshot? An IPO can be an expensive, long-term solution to a temporary problem—which is why the IPO market tends to dry up in a crisis.
Bank loans. In general, we see limited borrowing from startups. Traditional loans are costly, take longer than immediate needs require, and can tie down a company with unfavorable terms for years. For their part, banks face more repayment risk with market volatility. Private companies that pursue this route may have to accept a higher interest rate or not get approved for a loan at all.
Government assistance. Funding from the CARES Act and other relief packages has been hard to come by and is often reserved for specific sectors. For instance, the Paycheck Protection Program ran out of cash within days and largely depended on banking relationships that many startups lack. Government aid also may come with rules around employment, executive compensation, or other factors at odds with the company’s economics.
Bridge Notes to the Rescue
Bridge notes can cut through a number of these problems. As a short-term loan meant to “bridge” a company into the next round of financing, these notes usually are for smaller amounts than a full funding round. At the end of the period, a bridge note can be converted into equity in the company at a fixed price, often at a premium or with special terms for investors.
In times of market uncertainty, these terms offer many benefits to both investors and companies, including:
- Price certainty. This is one of the concerns that can stop investment banks and private equity firms from investing in the first place. By locking in terms for the conversion to equity, funders are more likely to agree to terms that will be beneficial to them. Also, investors get downside protection in that they will still get repayment of the note and principal. In addition to removing obstacles to funding, price certainty makes it easier for investors to assess the true value of a company. We’ve even seen less sophisticated investors step in, with comfort that the future round will be a negotiated transaction allowing them fair terms and a premium.
- A shorter term. This helps both the investor and the business in disruptive times. From the company’s perspective, there’s no multiyear lock-in with unfavorable terms—especially important when the market situation could turn around in a year or so. From the investor’s perspective, giving money to businesses over time (instead of all at once) offers flexibility and limits risk. In both cases, the short-term factor allows everyone to wait and see before more significant moves.
- Immediate cash. For a business, timing can spell the difference between life and death. Does a startup really want to lock themselves into a preferred round at $10, despite a long-term fair value of $15? The company will receive less money, and the transaction reflects poorly on the company’s prospects due to investor anchoring. The lesson is that a large investment isn’t always the answer. Sometimes, the better path is to focus on the vision and just use a bridge to get to the next major round or issuance.
The volatility in markets in the last few months reflects deep uncertainty about the future expectation of the economy. And for now, it’s creating ripples like the ones we’re seeing for startups. Although no tool is perfect for a situation like this, convertible bridge notes can be a clever way to sidestep the drawbacks of traditional funding sources and help fledgling companies persevere.