June 6, 2009

A Convertible Bridge is better than Equity for your Seed Round

For most seed rounds, a convertible bridge structure is better than Series A Preferred Stock. Convertible notes have the following advantages:

• Faster time to close. There are simply fewer terms to negotiate (less than 10 actually) versus Preferred Stock (closer to 50). As a result, the term sheet can be a page a long.

• You don't need a lead investor. Because of the simplicity of the terms, the Company can lead the process and close on multiple closings with investors over time.

•Investors can lock in the pre-money valuation. A convertible note doesn't mean investors need to give up locking in a pre-money valuation - the principal argument raised in favor of equity. The convertible note can provide that on the next equity round, the notes convert at the lower of the next round valuation or the locked-in valuation stated in the note. In this way, investors are assured the percentage ownership of the Company they've negotiated and the Company has avoided the costly and time consuming process of selling equity in its seed round.

•Less Expensive. Faster time to close and simplicity means fewer transaction expenses. In our experience, convertible note rounds cost a Company less than $5k (investors also usually don't use legal counsel), whereas equity rounds can cost up to $50k ($25-$35k for Company fees plus investor legal fees which are usually reimbursed to the lead investor).

•Investors get Venture Capital terms. When the notes convert, they will convert into the same Series A Preferred Stock (with all its bells and whistles) that the lead VC investor will negotiate at that time. Bridge investors will get all the same terms as the venture investor (except perhaps a better valuation!) and can piggyback off of that investor's negotiation skills.

•One Series of Stock. Converting all notes in the future into the same preferred stock that a future VC investor buys is best for the Company as well. It means all investors will hold the same series of preferred stock. This is more manageable for the Company going forward.

Convertible Bridge Terms are as follows:

•Size of round - usually a range or target.

•Multiple closings over time - you close each time an investor wires money to your account.

•Maturity Date - usually 12 or 18 months from first close.

•Conversion - automatic conversion on Series A of a certain threshhold size.

•Valuation or Discount. The notes will either convert at the pre-money valuation terms as described above or at a discount (usually 15-25%) to the Series A price.

•Interest Rate - the minimum applicable federal rate - which is now less than 1%.

•Legal Expenses - each investor pays its own legal counsel if they decide to use one.

•Amendments - the note terms can be amended by a majority of the noteholders. This is important for future flexibility.

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