A bridge (round) to somewhere

We’re living at a time when valuations are very high, as Fred Wilson and Ari Newman have both recently pointed out. When valuations rise, so do the caps on notes, which are upper limits on valuation at conversion.

In many cases the caps are very high because the entrepreneurs are telling the investors that they’re super confident they’re about to raise a larger round and they just need to “bridge” the company to that larger round. The reason the entrepreneur want a high cap is to signal a high price for the next equity financing of a larger amount of money. If they accept convertible notes now at a low cap, how could they possibly justify a higher equity price in a few short months when this larger financing is bound to happen?

For example, a company may be raising $1M in notes at $15M pre-money valuation cap with a 20% discount. They’re doing this, because they’re “so close” to raising $5M in equity at $15M pre or more! Part of their story to their bridge investors might be that this $5M equity financing is imminent, and that the investors in the bridge notes are getting a discount (typically 20%) to that “just around the corner” equity round. What a deal!

But if this is a company that has limited progress and no business normally getting to a $15M pre-money valuation, it’s obviously going to be hard for investors to swallow that cap. But of course, they realize that it’s only a cap, and in actuality the next financing may happen at a lower price. So maybe the investors will consider investing anyway. And I often see them do so, and what follows is predictable. Uh oh! There is no large equity financing, and they’re now in a company with a $15m conversion cap instead of a $5M conversion cap. They assumed they company would be worth more sooner with a large influx of cash. But it’s not. Now years go by and finally the notes convert at $10M due to the eventual slow progress of the company. Great, that’s still better than $15M, but it’s twice as a bad as $5M from the investors perspective.

When I’ve faced this situation of the larger financing being “just around the corner,” I’ve used a conversion clause that says the agreed (high) cap is valid only for a year, and if there’s not a qualified financing (of, say $5M) within a year, the cap would go to a lower number that I feel is more in line with their current value. I’ve found this to be a handy solve for this situation. And, perhaps more importantly, I learn something from the negotiation.

If the entrepreneur says they’re fully confident they will raise the qualified financing within the year, then they should be more than willing to accept the reasonable but lower price in the event that they don’t!

As an investor, the red flag that I pay attention to is if the entrepreneur is hesitant to include that alternate conversion clause in the case where there is no qualified financing within the agreed timeframe. That tells me that they’re not *actually* very confident that they’re going to raise the larger equity financing, and that I should take that into account as an investor. This is one way to suss out how confident they are that they’re going to raise that higher priced equity round.

Ultimately, the terms should match the story and this is just one way to make sure that they do.

So, if you’re a founder or CEO and you believe you’re bridging to an imminent larger financing, and you find yourself wanting to “signal a high price” via the note cap, one way to make your life easier is to agree to use a lower conversion cap in the event that the financing that you expect doesn’t happen in some reasonable timeframe. It will be an easier sell to your investors. And, if you’re truly confident in the upcoming higher priced round, it doesn’t really cost you anything.

Seem reasonable to you? Have you done something similar?


file under: Startups
  • Sue

    This post is stellar. “Terms should match the story.” Love that simple, elegant lens.

    • David Cohen


  • Phil Nadel

    Great idea, David. Thanks for sharing. From my perspective, the big question is should a note cap approximate the current valuation of the company or should it reflect the projected valuation in the next anticipated priced round? As an early-stage investor, I do not like the idea of the cap today being based on a projected future valuation. I don’t believe that properly aligns risk and reward. In other words, when the note cap is based on a projected future valuation, I am not being properly compensated for the risk I am assuming today. Of course, if the company has no trouble selling these notes to other investors, then I risk missing out on the deal. But I refuse to let FOMO cloud my decisions around the proper balance between risk and reward based on what I know at the time of the investment.

    I would love to hear others’ perspectives.

    • David Cohen

      totally agree that the cap should be about “now”. the struggle is that you want to help them send a positive signal, and there’s often a disconnect between what pricing might be on a small round vs a large one as well.

      • Phil Nadel

        While I am sympathetic to the “positive signal” argument, this can also backfire if the company does not hit all of its milestones for the next round. A higher cap could make it more difficult to raise the next round, or at least to raise the next round at a valuation equal to or greater than the previous note cap.

        • David Cohen

          generally agree, although i’ve found that the higher cap only makes it harder to raise the next round relative to the founders expectations. investors don’t mind offering what it’s worth and they realize that the cap is just a cap, not a price. the entrepreneur seems to forget that frequently.

          • I have found that some investors are reluctant to invest when they believe the proper valuation should be less than the previous cap. But generally, I agree with you that it’s more of an issue with founders who don’t want a down round.

  • Bob Mason

    We’ve used this technique well with more traditional bridges that come from inside investors. We have full visibility into potential pipeline, conversations, etc, but no deal is done until the money is in the bank. In that circumstance we’ve set the time trigger to shorter periods, like 3-6 months, which I feel is probably better connected to present versus future opportunity.

    • David Cohen

      yep, another reasonable situation where it makes sense.

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