The general logic of venture / growth equity finance is to time major fundraising campaigns with inflexion points in the issuing company’s growth trajectory, such that the company is able to mitigate dilution by raising large amounts of capital at successively greater valuations (see the article “Two Sides of the Same Coin: the Direct Relationship between Valuation and Dilution in Pricing Venture and Growth Equity Deals”). To implement this strategy, a company will aim to raise just enough cash in its “priced round” (e.g., Series A, Series D, etc.) to provide it with sufficient runway to reach its next valuation catalyst (e.g., proof of concept, first strategic partnership, successful clinical trials, etc.), with a modest buffer for contingencies. This approach compares favorably to a company raising enough capital in a single priced round to cross multiple inflexion points, since the company would be raising at a relatively low valuation that does not credit the pro-forma achievement of the various milestones.
However, some risk will always exist that the company misperceives the length of the runway required (or unexpected events create delays or a financial drain) which cause the company’s reserves to come up short. In this regard, careful dilution management is at odds with the desirability to have a strong and durable balance sheet (particularly for a young, risky business). It is within this tension that the bridge instruments provide a needed solution.
Convertible notes and SAFEs are the most common forms of bridge instruments. At their core, these instruments are tools to bridge the funding gap between the point at which the company has run out of cash and its next inflexion point by (i) allowing the issuer to raise the minimum amount of necessary powder, while (ii) avoiding the risk of overcapitalizing at a lower valuation.
From an investor’s perspective, there are two key features of bridge instruments. First, a bridge instrument will convert into the same preferred equity issued in the next priced round (which can be assumed to include market standard terms in favor of the investors), but at a percentage discount to the price per share implied by that priced round. If the discount rate for the investor is 20%, then at conversion the note effectively “purchases” shares of the new preferred stock at eighty cents on the dollar, which has the practical effect of increasing the investor’s purchasing power by 1.25x (i.e., 1 / 80%). As a result, the investor receives an immediate paper gain on their investment as soon as the conversion occurs.
Second, bridge instruments include “valuation caps” which ensure that the investor also participates in any significant appreciation of the company between the bridge instrument issuance and its conversion. A “valuation cap” is essentially an agreed valuation of the company as of the date of the bridge instrument is issued. In a scenario where the valuation cap is $10mm and the company ultimately raises a priced round at a pre-money valuation of $30mm, the investor is still treated as having invested at a $10mm valuation at conversion and, as a result, the investor will practically have a purchasing power of roughly 3x ($30mm / $10mm) (noting that other factors will adjust this a bit). In bridge instruments, investors almost always have the right to convert at whichever of these two approaches (percentage discount or valuation cap) results in the greatest number of shares to the investor.
While these mechanics provide investors with the necessary incentive to invest prior to the priced round, they also provide important dilution avoidance for the existing shareholders of the company.
Here is a simple example that demonstrates the dilution avoidance benefits of a bridge instrument vs. a priced round:
Company is a medical device company that raised money in a prior round at a $25mm post-money valuation with the expectation that those dollars would be sufficient to get it to a 510(k) clearance from the FDA for its core product, which would represent a substantive de-risking of the company’s prospects and facilitate its ability to sell product to consumers, which the company believes will allow it to command a $80mm pre-money valuation in a new priced round.
Once the clearance is received, the company expects to build inventory and execute a go-to-market strategy which will require $20mm of cash, which would represent 20% overall dilution to the existing owners (i.e., $20mm / ($80mm + $20mm)).
However, the approval is taking longer than expected, and the company needs to raise more money to stay afloat. The company expects to need $2mm now, which will reduce its future needs by a corresponding amount.
One option would be for the issuer to raise the priced round now, but it expects that if it were to do so, it would struggle to command a pre-money valuation in excess of $40mm. So, if it were to raise the full $20mm now, the existing owners would experience ~33.3% dilution (i.e., $20mm / ($40mm + $20mm)).
However, if it issues a bridge instrument for the $2mm (at a valuation cap of $40mm – which means that at conversion the $2mm will represent ~5% of the issuer (i.e., $2mm / ($40mm + $2mm))), and then raises the remaining $18mm at the expected $80mm valuation, then the resulting dilution to the existing investors taking into account both the bridge and the priced round would be ~22% (i.e., $18mm / ($80mm + $18mm), which equals ~18%, plus the further dilution by an absolute ~4% to account for the issuance of ~5% equity to the bridge instrument investors (which ~5% equity is in turn is diluted by the $18mm investment)).
As a result, using a bridge instrument only increases the incremental dilution by a relative 10% (i.e., 22% / 20%), as opposed to a 65% increase in dilution (i.e., 33% / 20%) if the full round were raised at the $40mm pre-money valuation.
Used properly, a bridge instrument can be an excellent tool to solve a capital deficit for a company in a minimally dilutive way, while still providing the investor with all the structural attributes of an attractive investment.
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If you have any questions, please contact your primary attorney at Seward & Kissel LLP or Gary Anderson at anderson@sewkis.com or Eric Buchanan at buchanan@sewkis.com.
