In this difficult environment, many start-ups are deciding which financing vehicle would be best to enable them to continue to move forward toward their goals. The instinct is to jump into a next round of equity financing. Before making this decision, however, a company should consider the potential effects of a valuation event on the company at that moment, including the effects on the prospects of any future equity rounds of financing.
Although a start-up may choose to offer an additional round of equity (e.g., A-Z round), the pricing of such equity will require the company’s board of directors to set a value on the company. Importantly, the timing of a valuation can be critical in determining the success of the equity round, especially if the start-up is in between milestones. If the board of directors sets a valuation that is too aggressive (i.e., high), then it may diminish the ability to raise new money and, even if there were a group of interested investors, may lead to other unfortunate consequences on a subsequent round.
For instance, a high relatively valuation raises the bar that a start-up must clear on a subsequent round of financing. If the bar is set too high, the pricing of the next round may necessitate the dreaded “down-round” with all of its consequences (e.g., anti-dilution adjustments, etc.). If the valuation is too soft (i.e., low), then it may force current shareholders to question the economic condition of the company and further imply that the company is not performing in accordance with expectations. For instance, if the start-up closed its C round at a price of $7.00 per share a year earlier and sets a $7.00 per share strike price for its upcoming D round, the C investors would see no added value to their investment. In this case, the company may seek to postpone the valuation event so as to avoid an unreceptive investment community on the one hand and an unhappy existing shareholder base on the other.
What is a start-up to do? One very common way to postpone this valuation event when a company finds itself strapped for cash and in between milestones of its business plan is to offer debt (i.e., notes) with some kind of equity feature, such as attached warrants or to make the debt convertible and/or with attached warrants. These notes can be unsecured or secured, typically accrue interest in the range of 6-12%, and then convert to the next equity round when the company is in a position to close on that round. The company’s expectations of when it will close on the next round usually determine the maturity on the notes. For instance, if funding should be just around the corner, then a shorter maturity period is warranted. Presently, companies are seeking somewhat longer maturity windows just to conform to current financing conditions.
Notes with an equity feature serve the interests of both the company and the investors who want to help out the company. The notes serve the company’s objectives to get them to the next milestone (and, hopefully, the next up-round of financing) without taking on the dilutive effects of a down-round. Furthermore, from the investor’s perspective, note holders would be paid out before equity investors (and, perhaps, even before general creditors if the notes are secured) in the event that the company never makes it to that next milestone and is forced to liquidate, which makes the offering more attractive from a risk-analysis point of view. Bridge rounds based on convertible debt often come with a sweetener (e.g., a discount on the conversion via an attached warrant that enables the investor to obtain additional shares or simply by adjusting the conversion ratio so that it is better than one-to-one) to attract potential investors and to compensate them for the increased risk associated with investing before the closing of a formal equity round. In the past year, many of our clients have chosen to bridge between equity rounds in an effort to take care of immediate cash-flow concerns and get themselves into a position to close on the next equity round. In this kind of situation, a “bridge” is a usual and well accepted strategy.