Bridge financing for Silicon Valley start-up companies is a fairly standard, relatively inexpensive method to raising money pending a larger investment round. This type of financing is typically provided in the form of debt that converts into shares issued in the next funding round, often at a discount from the per share purchase price.
Recently, the simple convertible bridge loan has changed to provide substantial tax incentives to investors. For any qualified small business stock, or QSBS, purchased before December 31, 2011, the recently enacted 2010 Tax Relief Act allows 100% of the gain recognized from the stock to be excluded from taxable income.
Although a convertible loan will not qualify as QSBS, the stock that a start-up company issues normally will. Bridge loan investors have a great incentive to purchase stock in exchange for their bridge funds instead of a convertible note. Designing stock that has many of the same attributes as convertible debt has provided some additional complexities to what was formerly a plain vanilla transaction.
Because debt is not being issued, the investor will have no right to return of its funds, barring securities violations. Most bridge loan investors, however, provide funds on the expectation of ultimately holding stock. As a result, the lack of a repayment feature is not a concern. If it is, a redemption feature could be designed, but it is unlikely the Company would be able to legally redeem the stock if it couldn’t otherwise raise money.
The key advantage to a convertible note, that value need not be negotiated, is eliminated because stock is issued. This creates the need to negotiate a valuation, which adds time to the transaction. This can be solved, in a sense, by requiring the stock to convert into stock issued in the next round if the next round is expected to close soon. If this approach is used, a separate and forced conversion rate must be established to make sure the bridge stock converts into the next round.
As a result of the above items, and the need to issue stock, a new series of stock will need to be created. This requires charter documents to be amended and corresponding board and stockholder approval to be secured.
Price-based antidilution adjustments may be triggered. If so, capitalization estimates have to take account of corresponding changes in the conversion rate of the applicable series of preferred stock.
Tax benefits will come at some cost in the deal due to more complex documentation and expense. The structure, however, may provide just the right push to close that extra funding.