Bridges to Nowhere
Bridge notes can provide investors with a discount in exchange for putting up money along the way to a major financing. Bridge notes can allow an individual or small fund to get into a deal when there might not be room in a round being funded by larger institutional investors. Bridge notes leave price negotiations to independent (often times angel investors personally know the entrepreneur) experienced investors. I have recently been asked to evaluate two investment opportunities that came from friends who are active angel investors. As is common, both of these deals were structured as bridge notes. Both of these deals suffered from the condition we call “A Bridge to Nowhere”.
Like the famous Ted Stevens earmarked bridge in Alaska, a bridge to nowhere can cost a lot of money with the added pain it is your money, not just some tax payers from the lower 48.
Bridge to Nowhere Symptom #1: Not Enough Capital Being Raised
Every investment round should have enough money in it (with buffer for unanticipated shortfalls) to fund a company to the next funding milestone. This is not a precise science. There are many ways these milestones can be cast, but regardless they need to be able to answer positively the question “will the accomplishments be sufficient” to motivate new investors to join the party. In a company without professional investors, this can be a big hurdle. This involves real on the ground accomplishments (beyond spending the cash on hand). Putting 1M into a deal that is going to require 5M – 8M to generate enough traction to attract a deep pocketed professional investor isn’t wise.
Bridge to Nowhere Symptom #2: Terms That Spoil the Deal
We have always been advocates of using the cleanest term sheet possible. Avoid special preferences, ratchets, punitive clauses we are definitely out of the build the company and good things will follow school of investing, others make good money by financial engineering.
Bridge to Nowhere Symptom #3: A Badly Priced Round
This one is a bit of an oxymoron, but bear with me. We recently saw a deal where the company had set a price for a small angel round. The price was, needless to say, very company friendly. This has bridge qualities, these funds will carry the company until it needs a larger professional round or the company becomes self sustaining. This next round has four potential pricing outcomes:
- No additional funds are needed. The angels now own a small illiquid piece of a small business.
- All is incredibly great and new investors are willing to do an up round.
- More money is raised at the current price, which means todays money overpaid.
- The only way to raise money is in a down round. Down rounds are bad for the current investors and cast a negative light on the company.
Is it ever prudent to invest in a bridge round. Absolutely.
- When the funding source for the next round has been identified and has a high likelihood of completing the deal.
- When there are deep pockets already at the table who believe in the deal and are willing to continue funding the company.
As a smaller fund, we frequently take bridge positions so we have a seat at the table. Good deals are a bit like musical chairs and small $ tend to get shoved off the last chair by bigger dollars.