Seed Financing Option: Convertible Debt with Warrants

07 Dec Seed Financing Option: Convertible Debt with Warrants

So-called “bridge financings” between rounds of venture capital financings often take the form of convertible debt with an “equity kicker,” usually in the form of warrants.  A typical scenario might involve a company – let’s be creative and call it Newco – that has previously raised money from a group of venture capital investors.  Let’s call them the Old Investors.  Newco is now out to raise additional funding, but needs some cash to keep moving until the new round gels.  Assuming the Old Investors are otherwise well-disposed towards Newco and more or less confident that Newco will ultimately raise the new round of money, they might advance Newco some money – let’s assume $1 million for illustrative purpose – in exchange for a $1million convertible note and a warrant to purchase, say, $100,000 of the equity issued in the next round of financing at the price (not yet determined) applicable in that financing. 
In conventional parlance, this would be a $1 million bridge in the form of a convertible note with 10% warrant coverage (the 10% refers to the size of the warrant compared to the size of the note).
The amount of warrant coverage in a typical bridge financing is usually somewhere between 5% and 20%, depending on a number of factors, including most critically the confidence the Old Investors have that the new financing round will actually happen, the likely timing of the same, and, frankly, what the Old Investors can sell to Newco and, just as important what they think they can sell to the hoped for new investors in the anticipated financing round.  In all events, this “convertible debt w/warrants” formulation is a well-established practice in private equity and venture capital bridge financings.  It gets Newco some needed cash in anticipation of a new round of financing the terms of which – including price – are still up in the air.
Teaching an Old Dog New Tricks
The virtues of the note/warrant financing structure are three-fold: first, it allows the parties to hedge on the price, in that the conversion price is based on the yet-to-be-determined price of the next round of financing; second, the warrants reward the investor for taking the risk of passing money across the table before there is any guarantee that there will be a new round of financing; and third, the note offers some protection, in so far as with respect to the note the Old Investor is positioned as a creditor, in the event the new round does not take place and the company folds.
The note/warrant structure discussed above is a very good fit for bridge financings where there is some reasonable expectation that future financing will in fact come through.  But are there other scenarios where the note/warrant financing might also be a good fit?  One possibility is the seed financing scenario.  More particularly, the seed financing scenario where on account of the early stage of the opportunity or the alternative views of the entrepreneur and the prospective seed investor there is no meeting of the minds on the valuation (price) of the company at the time of the seed investment.
Convertible Notes w/Warrants in the Seed Financing Context
Let’s suppose we have a seed stage company – call it Seedco – that has identified a prospective investor – call it Seed Money – that would like to invest in Seedco except that the parties can’t agree on price.  This scenario looks, functionally, a lot like the traditional bridge financing situation: Seedco, like Newco in the bridge scenario, needs money now and Seed Money, like Old Investor in the bridge scenario, is ready to invest but doesn’t know what the price (and probably other terms) should be.  A convertible note with warrant financing looks like an ideal fit.  And it can be, to a point.
While the seed and bridge scenarios sketched out above have a lot in common, there are some important differences that need to be taken into account.  Foremost among these is the relative certainty that there will be a “next round” after the seed/bridge round.  Newco, in the bridge case, is a more mature company: it has previously raised capital at some set price; most likely has a more complete team; and almost certainly has a better grasp of the magnitude and risk of its business opportunity.  When you add those factors up, Newco is a much “safer bet” to raise future financing than Seedco, and the likely price of such financing is easier to estimate.
Given these differences, could the note/warrant financing structure used in the bridge financing scenario still be a viable option for Seedco?  In many cases, I think the answer is yes, subject to some tweaking of the model and some important limitations.
As for the tweaking, the part of the transaction needing attention is the warrant coverage, which compensates the investor for the risk that there will not be a subsequent financing.  The likelihood, size and price of the next round of financing are all subject to much more uncertainty in the seed financing scenario than in the traditional bridge financing scenario.  And risk, as you learn in life if not in school, and reward are closely related.  So, Seedco can expect to have to offer Seed Money substantially more warrant coverage than Newco will have to offer Old Investor.
How much more?  The best way to think about that is in terms of what kind return Seed Investor needs/should get for taking on the added risk of investing at a time where there is so much uncertainty about future funding prospect.  In my view, the question to ask is what kind of bump in price would Seed Investor need to see if instead of the note/warrant structure it invested at a fixed valuation?  A good rule of thumb – for most but not all situations – is 25% to 100%.  It could be lower if Seed Investor is looking for community economic development returns and not just maximizing investment returns. 
If 50% to 100% seems like a lot, well, it should be.  Remember, Seedco wouldn’t be investing at the seed stage unless, on its seed investment, it expected to earn a higher return than subsequent investors would expect to earn on their presumably less risky downstream investments.  In risk/reward terms, why take on the added risk of investing at the seed stage unless there is more reward offered?
Based on the above, a “typical” use of convertible notes w/warrants in a seed stage situation might include $X worth of convertible notes with 50% warrant coverage.  That is, Seed Investor would get a note with a face value of $X (say $100,000) and a warrant to purchase $.50X ($50,000) of the stock issued in the next round of financing at the price applicable in the next round of financing.  Voila: the problematic valuation discussion at the seed stage is tabled; Seedco gets the money; and Seed Investor gets a reasonable upside if the deal takes off (the warrant) and some modest protection if the deal goes south (the note).
Practical Limitations
While the traditional note/warrant bridge financing structure can be modified to fit many seed financing scenarios, there are some important limitations.  Perhaps the biggest limitation is the “tail wagging the dog” problem which occurs when the size of the seed financing and associated warrant becomes too big relative to the size of the anticipated later round of financing.  If the warrant is too big, the valuation discussion at the subsequent financing will be dominated by the “overhang” represented by the warrant.
For example, suppose the next round is targeted for $1 million in new money (that is, cash in addition to the conversion of Seed Investor’s note).  Seed Investor has been issued a note for $1 million and a warrant with an aggregate exercise price of $500,000.  When Seedco approaches new investors for the next $1 million round the valuation negotiation will inevitably be seriously skewed by the fact that Seed Investor will be, in effect, getting control of $1.50 million of the proposed new stock issuance ($1 million for converting the note and $500,000 controlled by the warrant) while the new investors will be getting only $1 million of new stock.
In figuring how much is too much in a seed note/warrant financing, the key variables are the size of the seed round relative to the size of the anticipated following round and the size of the warrant relative to the same.  If the seed round is very small relative to the anticipated size of the following round, the warrant coverage could be very substantial – even 200% or more.  Conversely, if the seed round is one-half or more the anticipated size of the following round, as in the example above, warrant coverage of even 50% could be problematic.
Some Caveats
A couple of caveats.  First, whether in the context of a traditional bridge financing or a note/warrant seed financing, the note/warrant structure does not immunize the investor against the rule that “he who has the money makes the rules.”  Historically, seed investors – because they usually lack the cash to do the next round by themselves – are prone to be washed out by subsequent deeper pocketed investors.  While a seed investor with a note may be in a somewhat better position to resist such treatment, the fundamental rule still applies and the seed investor can still be pressured by the subsequent round investor to surrender some or all of its warrant protection.  Still, the seed investor with a note and warrant is in at least as good a negotiating position vis the next round investor as the seed investor with naked equity.
The second caveat is that the above discussion is not meant to be a comprehensive analysis of note/warrant financing issues.  In order to focus on the “big picture” application of the note/warrant structure in the seed financing context, important details, such as interest rates, maturity, security for the note (if any), and what happens if there is no subsequent financing but the company keeps going.  Some subtler points, such the strike price of the warrant (it doesn’t have to be the price of the next financing) and the securities subject to the warrant (they don’t have to be the shares issued in the next round), are left for another time.
Other columns by Paul A. Jones

• Venture capital syndication
• Considering venture capital: Preliminary questions for entrepreneurs
• Technology transfer: Why private profit is good public policy
• Commercial Biopharma in Wisconsin: The next big step
• VC fund “flavors”