By: Mark Graffagnini, Graffagnini + Associates, LLC, www.graffagninilaw.com. Mark and his law firm focus on legal and business issues for entrepreneurs and investors. mg@graffagninilaw.com
In the last few days, at least 10 entrepreneurs have asked me what I think about doing a convertible note round before they raise a larger financing round in Spring or Summer. As we approach New Orleans Entrepreneur Week, SXSW and all of the other events for investors and entrepreneurs to interact, this becomes a more common concern. Your individual situation will determine whether you should raise a bridge round, but here are some things to keep in mind:
- Bridge rounds can buy you more time and runway to negotiate a better deal for your next equity financing. This strategy could give you more leverage in negotiations with a large investor for a Series A or B.
- A convertible note financing can be cheaper than an equity round, but it is not always cheaper. If you just closed an equity round and have documents that were negotiated by both sides, you might just want to authorize and issue more stock at a higher price or a flat price, assuming that your investors are on board with that. A convertible note round saves you the cost and expense of amending and restating your corporate charter and financing documents, so most of the time it will be cheaper and easier.
- Interest rates and discounts on the next round can upset your current investors. If you just closed an equity financing round, consider whether your investors will be irked that you are now giving new investors a “sweeter” deal on the next round than they have access to. If you are thinking about doing a convertible note round, you should talk to the folks whose approval you need to get the financing done—whether you do this sooner or later depends on your circumstances. It generally is a good idea to keep your investors in the loop regarding the financing needs and strategy.
- Cap or no Cap? In my experience, a convertible note with a valuation cap will essentially cap your next equity financing valuation. Lots of investors have asked for a valuation cap in their notes after the recession. They are becoming less common with investors I have worked as times get better. In this climate, you should think hard about whether you will agree to a valuation cap (or range). You may be better off with a larger price discount on the next round or a higher interest rate to address the investor’s risk. At least then you have the ability to negotiate your valuation without constraints. Of course, if your business faces dire financial straits and you are going to miss payroll without the note, then you might have to take the cap.
- Consider putting together a brief term sheet. It is unlikely that people are going to sign checks while you chat and socialize. If you have a brief term sheet saved and ready to go before you start mingling with investors, you might just save yourself time and money later scrambling to put one together after they express interest. Then again, you don’t want to seem overzealous or propose terms that are going to be an absolute turn off to investors, so use discretion. My old firm puts out a convertible note term sheet generator if you are in a pinch.
Best of luck to all of you heading out to SXSW and best of luck to you meeting other entrepreneurs and investors at NOEW.
Disclaimer: This post discusses general legal issues, but it does not constitute legal advice in any respect. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Silicon Bayou News, the author and the author’s firm expressly disclaim all liability in respect of any actions taken or not taken based on any contents of this post.
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