This article provides an overview of Bridge Notes (or Convertible Notes). If you're looking for information on the Bridge Notes workflow, you can find that here.
What is a Bridge Note (aka a Convertible Note)? A bridge note is a short term loan typically issued by a company to its investors before its first round of institutional investment or between rounds of financing. The idea is that these funds serve as the “bridge” to the next round of financing.
How does it work? Bridge Notes are convertible debt, so investors loan money to the company in exchange for convertible notes, which automatically convert into preferred stock in the next round of equity financing (for example, the Series A). In comparison to issuing preferred stock to investors, convertible notes keep the financing relatively simple and inexpensive. It also allows early stage companies to defer valuation (i.e. placing a value on the company as a whole) until the Series A round.
What are Some Key Terms?
Convertible debt usually includes a discount rate and/or a valuation cap:
Many deals offer investors a discount (ranging between 10-30%) on the preferred stock that they will receive when their note converts. The investor will pay a price per share that is, for example, 20% less than the price per share paid by the new investors.
So a price of $1.00 per share for new investors becomes $.80 for note holders who have a 20% discount. This is meant to reward your investors for backing the company when it was earlier stage and therefore more risky.
With a valuation cap, the investors are looking to “cap” the dilution of their investment by establishing a maximum valuation that will apply to the conversion in the future financing. In these cases, if your company has a higher-than-expected valuation during the equity financing, the note holder's conversion price will be calculated using the cap rather than the valuation used by the new investors.
What are the Key Documents?
Note financings involve a Note Purchase Agreement (which governs the financing as a whole and contains representations and warranties from the company), and a Note for each investor (the “IOU” which contains the terms of the debt and details on when it will convert to equity).
Board approval for these financings is required and some companies choose to get stockholder approval as well. Companies may also consider holding multiple closings to accommodate their investors' timing requirements.