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How to Raise Money Using a Bridge Loan or Convertible Note

If you’re raising money for your business from friends and family or angel investors, I recommend you consider using a convertible note or bridge loan to do it because it is typically cheaper and quicker than raising a “priced” round (in which you sell stock at a certain price).

Here are the main things you need to know about bridge loans/convertible notes:

Q: What is a bridge loan (or convertible note)?

A bridge loan/convertible note is simply interim financing until the next round of financing can be obtained. The word “convertible” is often used since the bridge loan will “convert” into equity at your next round of financing.

Q: Why use a bridge loan/convertible note versus selling stock?

  • It typically costs you less than selling actual stock — You can get a bridge loan administered for a couple of thousand dollars or less.
  • Fewer attorneys involved — Investors are less likely to ask their counsel to review it .because it tends to be a shorter document that is less complicated than a stock agreement.
  • You don’t have to set your valuation yet — A bridge loan is simply a loan that will convert into equity later when a valuation is set (typically during a larger round of financing).

Q: During which stage of financing is a bridge loan/convertible note most useful?

I find them most useful during the initial seed financing rounds of fundraising such as taking on a small amount of money ($500,000 or less) from private angel investors or friends and family (as opposed to venture capital firms).

Q: How long should a bridge loan be for? (what should the length of the term be?)

It will typically be one year or less (it should be timed such that the maturity date of the bridge loan is due roughly around the time that another financing (or liquidity) event occurs for the company.

Q: What should the interest rate for a bridge loan be?

A: The interest rates for convertible bridge notes vary but tend to be around five percent greater than the Federal Reserve rate (one point of reference: California laws dictate that there should be a cap of 10% on the bridge note interest rate).

Q: What happens if you reach the maturity date of a convertible promissory note and there hasn’t been another round of financing or liquidity event (and your company doesn’t have the money to pay back the loan)?

In this event, you can:

1) Ask the investor to extend the maturity date

2) Convert the loan into stock based on a price you pre-determined or a price you determine at the maturity date.

Q: What is a conversion discount (or warrants) for a bridge loan?

A “conversion discount”(or warrants) is a future discount that you provide to your investor (the person giving you the bridge loan) in the event that you do raise another round of money or have a liquidity event.

The conversion discount generally ranges between 20% and 40%.

So, for example, let’s say you get your bridge loan and offer a 30% conversion discount and then later you raise a Series A round of venture capital at $1 per share. Your bridge loan investor would then receive one share of stock for each $.70 that he loaned you.

Q: Do you have an example of a convertible note/bridge financing term sheet?

Here’s one: Convertible Loan Term Sheet

Q: Are there any drawbacks to taking a bridge loan?

If you take a bridge loan and can’t pay it back at maturity then an investor can technically use that as an “event of default” which could lead to bankruptcy — the way around that is to accept the bridge loan from someone close to you who you trust to see you through such a scenario.

Additionally, to protect yourself, you can try to get language into the bridge loan which converts the loan into something else (no matter what).

Final Thoughts

If you want to read more about bridge loans/convertible notes (which are also called “convertible promissory notes”), a great resource can be found at Convertible Notes by Yokum Taku, an attorney at Wilson Sonsini Goodrich Rosati (WSGR) in California, USA.

I have worked with the WSGR law firm on one of my startups and highly recommend their services. In fact, one of their attorneys was so good, I eventually hired him as our general counsel!

17 Comments

  • http://www.gomper.com David Steinberger

    Great post. Very useful information and great advice. One question….while you don’t *have to* set a valuation, it seems like without a cap, the investor is taking on the bulk of the risk. Is that still realistic in the current investment climate?

  • Rob Kelly

    Great point, Dave…I agree it would be tougher to not set a valuation in this economic climate.

  • David Williams

    What are the liabilities, if any, for a company issuing convertible notes where a conversion would take the outstanding shares over the authorized shares. Ie – is it necessary to establish a share reserve for any convertible notes issued?

  • robkelly

    Regarding the Conversion Discount, a lawyer friend of mine cautions that you should be careful about the behavior this may encourage from your Bridge Lender:

    “the conversion feature does create an economic incentive for your investors to want a lower valuation in the next round (due to the conversion discount which results in them getting more stock at lower price). If you are counting on your seed investors to help you raise the next round, this may not be a good thing.”

  • http://www.robdkelly.com Rob Kelly

    Regarding the Conversion Discount, a lawyer friend of mine cautions that you should be careful about the behavior this may encourage from your Bridge Lender:

    “the conversion feature does create an economic incentive for your investors to want a lower valuation in the next round (due to the conversion discount which results in them getting more stock at lower price). If you are counting on your seed investors to help you raise the next round, this may not be a good thing.”

  • gudfuk

    Ah ic biggy dic

  • kiramatalishah

    Anyone experience anything about the easy google profit kit? I discovered a lot of advertisements around it. I also found a site that is supposedly a review of the program, but the whole thing seems kind of sketchy to me. However, the cost is low so I’m going to go ahead and try it out, unless any of you have experience with this system first hand?

    http://www.onlineuniversalwork

  • Anonymous

    Anyone experience anything about the easy google profit kit? I discovered a lot of advertisements around it. I also found a site that is supposedly a review of the program, but the whole thing seems kind of sketchy to me. However, the cost is low so I’m going to go ahead and try it out, unless any of you have experience with this system first hand?

    http://www.onlineuniversalwork

  • robkelly

    My take on the Easy Google Profit Kit is to be very cautious. It's not authorized by Google and there are plenty of warnings out there about it at http://answers.yahoo.com/question/index?qid=200… and http://www.google.com/support/forum/p/AppSecuri… — some folks are using the word “scam” to describe this thing…so be careful!

  • http://www.robdkelly.com Rob Kelly

    My take on the Easy Google Profit Kit is to be very cautious. It’s not authorized by Google and there are plenty of warnings out there about it at http://answers.yahoo.com/question/index?qid=20090425194022AAitaHf and http://www.google.com/support/forum/p/AppSecurity/thread?tid=6a3f72dff51354af&hl=en — some folks are using the word “scam” to describe this thing…so be careful!

  • http://www.robdkelly.com Rob Kelly

    My take on the Easy Google Profit Kit is to be very cautious. It’s not authorized by Google and there are plenty of warnings out there about it at http://answers.yahoo.com/question/index?qid=20090425194022AAitaHf and http://www.google.com/support/forum/p/AppSecurity/thread?tid=6a3f72dff51354af&hl=en — some folks are using the word “scam” to describe this thing…so be careful!

  • robkelly

    Asheesh Advani writes a good article in Entrepreneur.com about Raising Money Using Convertible Debt.

    I like how highlights 3 decisions to make when using convertible debt:

    1) What will be the event that triggers the conversion?
    2) Will there be a discount upon conversion
    3) What will happen to the investment if the conversion doesn't occur?

    The whole article is here: Another good article on this topic is here: http://www.entrepreneur.com/money/financing/sta…

  • http://www.robdkelly.com Rob Kelly

    Asheesh Advani writes a good article in Entrepreneur.com about Raising Money Using Convertible Debt.

    I like how highlights 3 decisions to make when using convertible debt:

    1) What will be the event that triggers the conversion?
    2) Will there be a discount upon conversion
    3) What will happen to the investment if the conversion doesn’t occur?

    The whole article is here: Another good article on this topic is here: http://www.entrepreneur.com/money/financing/startupfinancingcolumnistasheeshadvani/article159520.html

  • http://www.robdkelly.com Rob Kelly

    Asheesh Advani writes a good article in Entrepreneur.com about Raising Money Using Convertible Debt.

    I like how highlights 3 decisions to make when using convertible debt:

    1) What will be the event that triggers the conversion?
    2) Will there be a discount upon conversion
    3) What will happen to the investment if the conversion doesn’t occur?

    The whole article is here: Another good article on this topic is here: http://www.entrepreneur.com/money/financing/startupfinancingcolumnistasheeshadvani/article159520.html

  • robkelly

    Asheesh Advani writes a good article in Entrepreneur.com about Raising Money Using Convertible Debt.

    I like how highlights 3 decisions to make when using convertible debt:

    1) What will be the event that triggers the conversion?
    2) Will there be a discount upon conversion
    3) What will happen to the investment if the conversion doesn't occur?

    The whole article is here: Another good article on this topic is here: http://www.entrepreneur.com/money/financing/sta…

  • http://www.takedebtconsolidationloans.co.uk/ Steve Madden

    The bad credit borrowers is not a major concern with lenders offering the commercial bridging loans because these loans are secured against the property.

  • http://www.ongig.com/ Rob Kelly

    Thanks, Steve. I appreciate your input. +r