Start-ups go through various stages of raising outside capital as they grow. It often begins with seed funding from founders and/or angel investors, continues through various rounds of equity funding from venture capital and/or private equity, and often ultimately leads to an offering. initial public (IPO). As companies move through this funding lifecycle, it is common for them to use bridge loans at some point to “fill” liquidity needs between funding rounds.
Many bridge loans pose a host of complex accounting issues that are often overlooked. As companies go through the IPO process, they are often required to review their accounting for these financial instruments.
In this article, I will highlight some of the common bridge loan terms that give rise to accounting complexities.
Common bridge loan structure
Bridge loans typically have short-term maturities of one year or less. Since bridge loans are granted when a business is likely to meet its cash needs, they carry a substantial risk of default. Therefore, investors often demand a higher investment return for their exposure to this credit risk.
Businesses seeking financing through bridge loans often have neither the inclination nor the ability to pay a high interest rate on their debt in the form of cash. As a result, these loans provide further rights and privileges to investors to induce them to invest.
Variable part payment
Bridge loans are often offered to investors who are expected to participate in the next round of equity financing. As such, it is common for bridge loans to allow or require the issuer to settle its obligation by delivering a variable number of its shares (i.e. variable share settlement). This allows the bridge loan to effectively serve as an advance on future equity financing.
The loan agreement often describes this feature as a conversion option; however, due to variable share settlement based on a fixed amount, this feature does not expose the holder to issuer equity risk at settlement. For example, the conversion option might indicate the following:
At the close of the next qualifying financing event, the principal plus any accrued interest of the bridge loan is automatically converted into equity securities offered at the next qualifying financing event at a conversion price equal to 80% of the issue price equity securities offered. at the next qualified fundraising event.
Below is an illustration of how the issue price of shares does not change the settlement value. At each issue price, the number of conversion shares is adjusted to give a settlement value equal to $25.0 million based on a $20.0 million principal amount of the bridge loan .
Conversion to fixed part
Additionally, bridge loans often contain other features that protect the investor in the event that the issuer is unable to close its “next qualifying financing event”. A common feature is a real conversion option.
True conversion options generally offer the lender the option of converting the bridge loan into a class of shares that existed at the time the bridge loan was issued. The conversion price is often set at the issue price of the most recent financing round or at the fair value of those shares when the bridge loan was issued. As the price is fixed, it exposes the lender to the fair value of the underlying shares.
Due to the complexity of the accounting literature governing these instruments, it is common for certain accounting issues to be overlooked. Below are some things that issuers should carefully consider when determining the appropriate accounting for bridge loans.
ASC 480 Considerations
Since the legal form of a bridge loan is debt, it would be recorded as a liability. However, since these instruments often contain variable equity settlements for a fixed monetary amount, the issuer should determine whether the bridge loan falls within the scope of ASC 480.
The bridge loan will fall within the scope of ASC 480 if it (1) requires the borrower (conditionally or unconditionally) to issue a variable number of shares equal to a fixed monetary amount and (2) that obligation is the result of predominant settlement at creation.
Careful consideration should be given when assessing whether the bridge loan meets the above two criteria, as the appropriate accounting classification may change depending on the specific terms included in the agreement.
Embedded Derivative Considerations
If the bridge loan is not subsequently measured at fair value (either under ASC 480 or through the fair value election under ASC 825), all embedded derivative features must be measured for bifurcation under ASC 815-15.
Although variable equity settlement features are often described as “conversion” features in loan documents, they generally do not expose the lender to changes in the fair value of the company’s shares. Therefore, they should be evaluated as refund features and not conversion features. If a discount is offered at the conversion price above 10%, there is often a substantial premium that triggers the recognition of derivatives.
A real conversion option must also be assessed; however, these should generally not be accounted for as embedded derivatives because they are gross settled in private company shares, which are not readily convertible to cash.
Advantageous Conversion Considerations
Additionally, if the issuer has not adopted ASU 2020-06, the issuer must determine whether the conversion functionality should be separated as part of the beneficial conversion functionality model. For more on ASU 2020-06, see the article titled “Why Consider Early Adoption of ASU 2020-06?”
Effective Interest Considerations
As stated earlier, bridge loans often have a lower contractual interest rate where the investor is compensated with the discounted conversion price. Consider the example above, where the investor actually received a 20% rebate on the next round. If the bridge charge paid a coupon interest rate of 5% and the expected term was one year, the yield would effectively be 25% (5% accrued interest and 20% via discounted conversion).
ASC 835-30 describes the total amount of interest over the life of a cash loan to be measured as the difference between the actual amount of cash received by the borrower and the total amount agreed to be repaid to the lender. For this reason, it may be appropriate to increase the repayment amount using the interest method, unless the fair value option is chosen.
To further complicate this analysis, the counting under ASC 480, 815-15 and 835-30 overlap. Care should be taken not to double count the impact on profits.
As Managing Director at Opportune LLP, Matt Smith helps companies account for complex financial instruments under US GAAP and IFRS. With over 15 years of client service experience at Opportune and Ernst & Young, Matt has acquired in-depth knowledge and expertise in debt and equity financing activities, derivatives and hedging, shares and SEC reports. He holds an undergraduate degree in accounting from Oral Roberts University and is a licensed CPA in the State of Oklahoma.