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?
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).
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!