Work Horse Redux

Joseph W. Bartlett

What I have described as the “Work Horse” in early stage finance is a convertible note, bridging the investor into a discounted piece of the next, presumably institutional round of financing …the Series A, let’s say. Herewith some thoughts on that subject; I am plagiarizing from what I currently have in print (see, and am repeating myself in order to emphasize an often overlooked rationale for this structure. And, for purposes of simplicity, I am not including what would call the West Coast version of the Work Horse, the SAFE

Just recently I was exposed to counsel for an investor in a Work Horse round who undertook to negotiate vigorously on the terms of the bridge note mandatorily convertible into the next round … i.e., the Work Horse. There were a number of missing points which, in that lawyer’s quite understandable opinion, one saw …and historically negotiated …in rounds of private equity financing. Thus (and I am making this up), what about noteholder consents to specific corporate actions? How about “Preemptive rights?” “Observer rights?”

The problem with that approach is that, for better or for worse, it misses one of the primary virtues of the bridge a/k/a “Work Horse” round.

Thus, the paperwork does not contain a lot of potentially controversial clauses which are customarily and fully negotiated in, say, an A round, or, in fairness, the Angel Round …, negotiations which cost money.

Second, except for the so-called “cap” (which is a post money valuation designed to protect investor from insignificance in the happy event the next round is in the stratosphere), the parties avoid the issue of pre money valuation, a sticky number in the absence of current revenue and net profits, particularly for companies in the early stages on the trip “from the embryo to the IPO.”

But why? Why, specifically does the process skip over provisions which indubitably are teed up and then discussed to the point of agreement in conventional private financings?

First reason. The Work Horse is much cheaper to draft and close, which can be key if Newco is still in its seed stage. It can’t afford the fees or the time. Secondly, the terms of the note are not the terms the company and the investor expect to live with … in the Series A round pending an exit. Those terms, which are to be fully negotiated, are the terms of the next round. Indeed, if you don’t think there is more or less certain to be a next round, the metric is: Don’t invest in the first place. But, if you do think the next round is on the way, live up to the thesis of the Work Horse.

And, a third reason to draft a KISS bridge note is the maxim, “Keep It Simple, Stupid.” The problem is that a single provision in favor of the noteholder … a consent requirement over given corporate actions … can muddy the waters for the “Seed” Preferred Round investors’ round designed to keep all hands in place as the Qualifying Round is on the horizon. Assume, for example, Seed Preferred investors for, say, $500,000 do not want a $50,000 noteholder to have pre-emptive rights to play in the Seed Preferred Round or the next version thereof. Granted that the Work Horse note is mandatorily convertible but only if the round is “qualifying” and Murphy’s Law provides that any special right may pose a problem for a holder bent on legal extortion.

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