Bridge funding rounds – top 5 issues for founder teams

The Covid-19 crisis guillotined revenues almost overnight in many sectors.  Cash is king right now.  Businesses that run out completely will most likely immediately drop dead.

Technology ventures that have recently raised funding will be thinking “thank goodness”, but the runway to deploy that funding has probably stretched out considerably.  And then any business plan agreed when closing the investment has likely been ripped up already.

Technology ventures that were hoping to raise funds about now may be in difficulties, whatever the venture capitalists say about great businesses being built in difficult times.

The best companies will still win funding from the VCs and may find themselves well positioned indeed in the new landscape that will emerge post-crisis.  Read our recent thoughts on what the funding narrative from here might look like.

But what do you do if you need cash?  Like, right now.

Many if not most technology ventures are poorly suited to taking advantage of the sweeping tax and finance measures introduced in recent weeks by the UK government.  See the latest position on that here.  That may change in some respects over the coming weeks.

A bridge equity round is perhaps the first option founder teams will think about.  And what follows below is our take on the top 5 issues to be thinking about if pursuing that option.

1. A bridge to where?

If you are raising bridge funding then it has to be a bridge to something or somewhere.  A bridge to nowhere has a drop into the void at the end.

And so a primary factor in successfully executing a bridge round is persuading new and existing investors that the bridge will get the business to the series B or to break even or whatever the target might be.

In HLaw’s experience, if there is not agreement amongst management, existing investors and new investors as to where the bridge is going then closing the bridge round will be painful, if it even closes at all.

What the existing investors choose to do is crucial.

In the current climate, the idea that a new investor would pump money into a business – when none of the existing investors are willing to follow their money – is unrealistic (save perhaps where an existing investor has already closed their fund).

New investors will worry that if existing investors aren’t going to step up to the plate it means they do not believe that particular portfolio company will survive.

2. Use convertible loan notes or an ASA, right?

Recently we wrote about the merits or otherwise of using convertible debt as a means of raising capital.  What we said was, beware of the hype and understand that the case for using convertibles is narrowly confined to bridge funding rounds where a valuation cannot be ascertained and cash is needed quick.

Well, since we wrote that piece the world has turned upside down.  But a convertible round is still an equity round and is not by any means the sole means of executing a bridge round.  The draw backs of using convertibles remain as set out in that same piece referenced above.

And proper thought needs to be given if any investor is seeking to benefit from EIS relief through the use of an advance subscription agreement – see our thoughts from January this year on that subject.

A straight equity round with cash exchanged for new shares will usually be speedier and less costly overall than a convertible round; but a straight equity round must have an agreed value.

3. Understand what a down round involves.

Many bridge funding rounds will be down rounds in the current climate.  Down rounds are not fun.

Existing investors who put their funds in earlier – maybe much earlier – have been tracking the IRR on the investment and factoring in a nice upward trajectory in their reporting to their LPs and their own investors.  With a down round, existing investors have new investors coming in later but paying a lower price.

Some existing investors may have an anti-dilution ratchet in the articles which will shelter their percentage shareholding on a down round.  Nevertheless, management will not.  And a down round plus exercise of an existing anti-dilution ratchet may and often does wipe out the founder equity.

The founders are the only ones who can actually run the business and create value.  If executing a bridge wipes out their equity then is the business going to work in the long term?

4. Understand that the terms of the bridge need to synch with the current equity structure.

HLaw sees this a lot.  Especially with term sheets for convertible loan notes.

The founders find and speak to investors who then put forward their own standard terms and negotiations merrily commence.  But existing investors will have a de facto veto most likely on the closing of the round.  And they are most unlikely to immediately accept whatever is put forward by the new investor and just give up all of their rights and protections.

That said, good existing investors will always work with new investors to keep the business capitalised.  It is very much in their interest to do so.  But ideally existing investors are involved with discussions from an early stage and whatever is put forward by the new investor is very likely going to need to carefully synch with the existing capital structure and documentation.

And that synching process takes time and needs to be carefully thought through.

If the company has raised EIS or VCT funds then any amendments to the capital structure should be checked by professional advisors to confirm that qualifying status will not be affected.  Founder teams and new investors should bear in mind that existing investors who have invested EIS or VCT funds will have their hands tied in terms of agreeing to structural changes that jeopardise those reliefs.

5. Solvency generally

Nobody likes to dwell on the worst case scenario.  But often if no bridge can be found then the cash runs out and that’s the end of the venture no matter the quality of the management team and the value of the proposed IP.  The board of directors for any distressed business need to understand basic principles of the dangers involved if trading whilst insolvent and should have a plan filed somewhere for (and think about whether they will want to be) “mothballing” the business with a view to it re-emerging post crisis with a better chance of success.

This piece was prepared by Henry Humphreys with input from Annette Beresford.

All the thoughts and commentary that HLaw publishes on this website, including those set out above, are subject to the terms and conditions of use of this website.  None of the above constitutes legal advice.  None of the above should be relied upon.  Always seek your own independent professional advice.

Humphreys Law