Venture in the Middle: Bridge Rounds in a Down Funding Environment
By Kevin Vela
This is my first installment of what I hope will be a regular series of thoughts on venture capital, from Texas. My goal is to provide perspective and balance in an environment when startups are launching all over the country, since much of what gets reported originates from a few behemoth venture ecosystems like SF and NYC. Today, I want to address bridge and flat rounds in light of the current venture climate.
The Venture Climate Coast to Coast
While this series will cover venture in Texas and the middle of the country more generally, at the moment the entire country is going through similar issues. PitchBook’s 1Q 2023 Venture Monitor tells us that venture financings are at a two-year low. This is one thing that we’ve certainly seen here at VW as the number of new equity rounds has slowed down. Even our fund clients are seeing longer periods in between deals.
On the one hand this is predictable given the current state of the economy; but on the other hand, it’s rather remarkable given the spike in new venture funds – especially smaller funds.
According to that same PitchBook Q1 2023 Venture Monitor, 2021 saw a massive spike in new venture funds, and 2022 remained very strong. All of these new funds need to put their capital somewhere, and for smaller funds it’s typically going to be deployed into early-stage financings because the investment amounts are less (which is good if you don’t have a lot of capital) and the diligence is less (which is good if you’re inexperienced – I’m not saying it’s right, this is just what we see). One reason that even these smaller funds may not be deploying capital is that given the overall economic climate they may be getting feedback from their limited partners that make these funds less likely to make capital calls.
This funding slowdown is not good news for startups. Startups need fuel (capital) to grow. This is especially true during downtimes. As a result, we end up seeing more bridge rounds, or flat rounds (those may or may not be the same thing) and even in certain cases, down rounds. With that in mind, I want to share a few tips for flat rounds or bridge rounds.
If it’s an equity round, ask for a slight uptick in valuation.
We frequently hear founders say they want to do a flat equity round because “it will be cheaper and faster if we keep the price per share the same and re-use the same docs.” As I will detail below, that’s not necessarily true, or at least not as cheap and fast as many founders think.
The work required for a flat round vs. an increased round is nearly the same, so why not increase the valuation a bit? The net effect to the investors (which are usually insiders) may be limited in terms of dilution and an increase in valuation will look good externally, and feel good internally. (If you want to argue that arbitrarily increasing the round isn’t an appropriate way of valuing startups then I’ll argue back with two points (1) startups typically get smarter over time because they have the benefit of experience, so that’s a reason to increase the valuation and (2) there really isn’t a standard way of valuing startups anyway.)
If it’s a convertible round, model it out.
Be prepared with a reasonable legal budget.
A lot of founders call me and say, “The lead investor said her fund will put in another $1M in equity, but let’s just re-use the docs from last time.” First of all, you can’t just “re-use the docs from last time” no matter how cheap your lead investor promises this will be. One reason is that the purchase agreement has a number of reps in it that will need to be revisited (this is very important to startups, especially during times like this) and another disclosure schedule will need to be carefully prepared. Both take time.
Secondly, you may need to amend the Voting Agreement, Investors’ Rights Agreement, and Right of First Refusal and Co-Sale Agreement. An amendment is short, but it’s a different document. Continuing, absent some extraordinary circumstances you will have to amend the Certificate of Incorporation, which in itself is not difficult, but the consent process will likely require consent from the entire board and certain investors, which takes time. You also need to watch out for Rights of First Offers that may be triggered – you’ll likely need to get waivers from those investors – again an additional time cost. So please don’t be misled to thinking that there’s such a thing as a “quick $1M extension equity round.”
Use this “round” as an opportunity to re-evaluate your board.
Are the board members truly providing value? Is this a good time to swap out an independent? Is there a preferred investor who is not going to participate in this round? Why not? Funds who invest in good times are commodities. Funds who commit to your company and are willing to provide more capital when the economic headwinds are blowing against you are true partners. If you’re going to go through the trouble of getting consents in place for the bridge round and amending certain docs, it wouldn’t require much more effort to update your board, if appropriate. It will be a negotiation. Especially if you are seeking to change or remove an investor board seat, but this is the perfect opportunity to have that negotiation, and it can make your company and board stronger for it.
I know it’s not what everyone wants to hear, but based on available economic data and what we’re seeing and hearing, it may be a few quarters before funding picks back up. Therefore, it is important to prepare your company for its potential “bridge round(s).” They may not be the valuations you hear about coming out of Silicon Valley, but they will be the fuel that can keep your startup moving forward until financings pick back up again.
Standard disclaimer here – these are just my thoughts and should not be interpreted as legal counsel. Please discuss your bridge round in depth with your investors and venture counsel.