In this article, I take a closer look at capital raising before Regulation A Offering and some key items to consider. This is a necessary follow-up to my December 2015 article entitled “How to Fund the Expenses of Regulation A Offering,” which describes how issuers that desire to raise capital using Regulation A could first or simultaneously raise capital through an offering of securities under Rule 506(c), which permits issuers to generally solicit and advertise their securities offering so long as they take the necessary additional steps to verify that each investor who invests in the offering is accredited. In my 2015 article I describe how an issuer may sell convertible bridge notes that convert at a discount to the price paid by investors in the Regulation A offering thus incentivizing bridge investors to invest early. Since 2015, I have gained a good amount of experience with actual bridge financings that precede Regulation A offerings and would like to share my insights.
Capital Raising before Regulation A Offering
Almost every issuer that is planning a Regulation A offering will raise some capital in a private placement (either traditional private placement under 506(b) or an advertised private placement under 506(c)) before its Regulation A offering. The terms of these bridge financings are more investor favorable than I initially expected. In my December 2015 article I suggested that issuers could offer a discount of up to 15% to the Regulation A offering price, but I am seeing much deeper discounts, including in one case a discount of 60% to the Regulation A offering price.
It appears that market interest rates are also higher than I anticipated in December 2015. I have seen interest rates as high as 15% and in at least one case the interest is payable on a current basis quarterly. Higher interest rates coupled with a deep discount to the Regulation A pricing are great ways to incentivize investors to participate in the bridge. For most entrepreneurs, it is worth giving up the higher interest rate and deeper discount to get that critical bridge money so that the company has runway to complete the Regulation A offering and ultimately execute the company’s business plan.
The total amount targeted for these bridge private placements seems to be between $500,000 and $1,000,000. Issuers do not have an appetite to raise more than $1 million on such favorable terms given the potential for high dilution. The use of proceeds in most cases is to fund the expenses of the Regulation A offering and for working capital purposes.
Issuers also seem to have an aversion to including any conversion cap in the bridge notes. A conversion cap is a ceiling conversion price at which the note will convert if the Regulation A offering is done at a very high valuation such that the discount does not provide much benefit to the investor who is coming in early. In my opinion, the absence of conversion caps in Regulation A bridges will become market given the expectation that the Regulation A offering will close within a few months (not years) from the closing of the private placement.
Another issue that arises with bridge private placements is whether a covenant should be included that requires the issuer to undertake the Regulation A offering within a specified period. In some instances, investors have even requested penalties (additional interest or conversion shares) if the issuer fails to meet specified deadlines for the closing of a Regulation A offering. So far, however, many issuers have been able to include only soft undertakings where the issuer describes an expectation that the qualified offering that will force the conversion of the bridge notes will be a Regulation A offering and that it expects to close such offering by a specified date.
Registration rights covering the shares underlying the bridge notes is another topic for debate between issuers and investors in bridge financings. Unfortunately, investors cannot just turn in their bridge note and receive qualified shares issued under the Regulation A offering statement. Instead, if an issuer agrees to register the underlying shares for resale as part of the Regulation A offering, the issuer must specifically include those shares in the offering statement as a secondary Regulation A offering occurring simultaneously with the issuer’s primary Regulation A offering. If the underlying shares are included in the offering statement they will be subject to the re-sale limitations of Regulation A which provide that only 30% of the aggregate offering amount may consist of selling stockholder shares. Issuers seem to be quite resistant to including the shares underlying the bridge notes in the offering statement and will also resist granting bridge investors any registration rights. Instead, I believe that issuers will agree to take such steps as may be necessary to permit re-sales of the shares underlying the bridge notes under Rule 144, including the disclosure of quarterly information, which is not required under the Regulation A reporting regime, but is an information requirement of Rule 144. Since in many cases the time between the closing of the bridge financing and the closing of the Regulation A offering will be at least six months, the shares underlying the bridge notes will be free trading under Rule 144 at or around the time of the closing of the Regulation A offering so long as the Rule 144 information requirements are met.
Several other terms may come into play in a bridge financing preceding a Regulation A offering. For example, investors may ask for a most favored nations clause or a sale premium. A most favored nations clause would give the investor the right to upgrade to better terms if the issuer does yet another private placement on better terms than the one the investor participated in prior to the Regulation A financing. A sale premium would give the investor some multiple of the investor’s investment amount if a sale of the issuer occurs prior to the Regulation A offering. For example, the investor might receive 1.5x the investor’s investment amount plus accrued but unpaid interest if the issuer is sold or there is some other change of control before the Regulation A offering.
I will be putting together an annotated term sheet template for a bridge financing that precedes a Regulation A offering. If you are interested in receiving a copy, please email me at firstname.lastname@example.org and I will make sure to send you a copy when it becomes available.
If you have any questions about this article or any other matter that I might be able to help with, please contact me at email@example.com or by phone at 202-203-8665.