This is an all too common question we get from management/directors of early-stage start-up companies. How should we structure our angel/seed investment.

Typically, this comes down to a choice between two approaches — a bridge (debt) round or a priced (equity) round. So how do you decide between the two?

Many early-stage investors lament the fact that valuations for early-stage business are often unrealistic (or even downright “crazy” to some investors). Deciding to do a “bridge” round removes the requirement to set a valuation on an early-stage business.

How can you determine if a bridge round is appropriate?

• Are you planning to raise additional funds from Venture Capital or other institutional investors?
• Are you planning to raise these funds in six to twelve months?
• Have you received positive inquiries from potential institutional investors?

If you answered ‘yes’ to each of these questions, a bridge round may be appropriate. Ultimately, a bridge round is an effective tool when it is a “bridge” to a later financing event. If you aren’t planning on such an event or are unlikely to reach it, then consider a priced round.

I advise most companies that intend to raise VC financing in the next 12 months to go with the bridge approach. Again, not always, but as a general rule of thumb. If there is less certainty about the likelihood (or even ability) then I say go with a priced round.

Founders will often ask “What do VCs prefer?”  Truthfully, it probably doesn’t matter either way for your future VC.  They are investing in the company based on the business rather than the cap table.  Make sure that if the bridge notes are convertible that they don’t have some crazy opt out provisions or some mechanism where the bridge investor can elect to receive cash rather than convert.  A VC doesn’t want a situation where they suddenly have to pay out a portion of the cash they just invested into your business back to some angel investor or your brother-in-law.  The key for a VC is a clean cap table without any hidden traps or odd structures.

Typical terms vary, but generally speaking we see something like 10-30% warrant coverage on the notes; or a conversion discount to the price of the Series A round also in that range. In each case, these numbers can be higher depending on the risk and stage of the company; or in other cases we see an escalating warrant/discount percentage as time goes on.

This approach saves you from having to worry about dilution until your Series A — and if you don’t reach the Series A round, then you agree to negotiate the equity conversion at that time.

The terms of a bridge loan are somewhat regional, so as a West Coast company you would likely fall somewhere in that space.