Companies often issue convertible promissory “bridge” notes when they are at an early stage and are in search of capital. A convertible promissory bridge note is a short-term debt instrument that, in addition to the standard terms (such as the principal amount owed, the interest rate, the maturity date, and default provisions), also provides that in certain circumstances, instead of cash payment of the amount owed under such note, the principal and interest accrued under such note may convert into shares of the company, in which case the note will be extinguished. The event that would normally trigger conversion would be the company raising additional equity financing by a certain date (e.g., the note may provide that if the company raises at least $1,000,000 of equity financing within the next 12 months the note will convert). The notes can be structured either as having a mandatory conversion from debt to equity or conversion may be optional and be up to the discretion of the lender. Often, the price per share that the note will convert into will be at a discount. For instance, if shares are issued in the financing at 1 dollar per share, the note may convert into shares at 80 cents per share and the number of shares issuable upon conversion of the note will be determined by dividing the principal and interest outstanding under such note by the discounted per share price. Such notes sometime include a valuation cap as well, which allows the note holders to convert into equity at the lower of the valuation cap or the price in the future financing, and may also contain a “most favored nations” clause which protects the note lender in the event that subsequent notes are issued on more favorable terms. The convertible debt held by the lender will typically convert into the securities that are issued in the future financing (e.g., Series A), although some notes may provide for terms whereby only common securities will be issued.
Companies must carefully track the issuances of notes and make sure to reflect these issuances on their pro forma capitalization tables to insure that any future rounds of financings take into effect the potentially large number of additional shares that will have to be issued as a result of the conversion of the convertible promissory notes then outstanding.
It is important to note that in recent years, one alternative to convertible promissory notes is the Simple Agreement for Future Equity (SAFE) that was created by Y-Combinator, a Silicon Valley incubator. In a SAFE, the investor’s funds are invested in the company in exchange for an agreement promising the investor company stock to be issued at a later date in connection with a specific future event such as an equity financing. The SAFE will typically provide the investor with a discount off of the price per share sold in the equity financing round and will include a valuation cap. In the event that an IPO or exit transaction occurs prior to an equity financing round, the SAFE can be converted into ordinary shares or repaid in cash, as elected by the SAFE holder. The SAFE is not a debt instrument (although the tax treatment is currently unclear), and thus bears no interest and has no maturity. Accordingly, the investor has no legal status as a creditor. On the flip-side, the Company need not reflect the SAFE as debt and does not bear the risk of insolvency attendant to loans.