Startup companies go through different stages of raising outside capital as they grow. This often begins with seed funding from founders and/or angel investors, progresses through various rounds of equity funding from venture capital and/or private equity, and ultimately often leads to an initial public offering (IPO). As companies progress through this funding lifecycle, it is common for them to take out bridge loans at some point to “bridge” liquidity needs between funding rounds.
Many bridging loans come with a variety of complex accounting issues that are often overlooked. As companies go through the IPO process, they often need to review their accounting for these financial instruments.
In this article, I will highlight some of the common bridging loan terms that create accounting complexities.
Common Bridging Loan Structure
Bridging loans usually have short-term terms of one year or less. Since bridging loans are granted when a company is at risk of meeting its liquidity needs, they carry a significant risk of default. As a result, investors often demand a higher investment return for their exposure to this credit risk.
Companies that seek financing through bridging loans often have neither the desire nor the ability to pay a high interest rate on their debt as liquidity. As a result, these loans provide investors with other rights and privileges to encourage them to invest.
Compensation with variable shares
Bridging loans are often offered to investors who are expected to participate in the next round of equity funding. Therefore, it is common in bridging loans for the issuer to settle its obligation by delivering a variable number of its shares (ie variable stock settlement). This allows the bridging loan to effectively serve as an advance towards future equity financing.
The loan agreement often describes this function as a conversion option; However, due to variable stock settlement based on a fixed amount, this feature does not expose the holder to issuer stock risk at settlement. For example, the conversion option can specify:
At the closing of the next Eligible Funding Event, the principal plus any accrued interest on the Bridging Loan will be automatically converted into the Equity Securities offered in the next Eligible Funding Event at a conversion price of 80% of the issue price of the Equity Securities offered in the next Eligible Funding Event.
Below is an illustration of how the stock issue price does not change the settlement value. At each issue price, the number of convertible shares will be adjusted to result in a settlement value of US$25.0 million based on a bridge loan principal amount of US$20.0 million.
Conversion into fixed shares
In addition, bridge loans often include other features that protect the investor in the event the issuer is unable to complete its “next qualifying funding event.” A common feature is a real conversion option.
True conversion options typically offer the lender the option to convert 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 last equity round or the fair value of those shares at the issuance of the bridge loan. Because the price is fixed, it exposes the lender to the fair value of the underlying stock.
Accounting Considerations
Due to the complexity of the accounting literature governing these instruments, some accounting issues are often overlooked. Below are some points that issuers should carefully consider when determining the appropriate accounting for bridge loans.
ASC 480 considerations
Since the legal form of a bridging loan is debt, it would be recorded as a liability. However, because these instruments often include variable stock compensation for a fixed monetary amount, the issuer must determine whether the bridge loan falls within the scope of ASC 480.
The bridge loan is within the scope of ASC 480 if it (1) obliges the borrower (either conditionally or unconditionally) to issue a variable number of shares for a fixed amount of money, and (2) that obligation represents the predominant settlement outcome at inception.
Careful consideration should be given when assessing whether the bridging loan meets both of the above criteria, as the appropriate accounting classification may change based on the specific terms contained 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 features of embedded derivatives should be assessed for dichotomy under ASC 815-15.
Although variable stock settlement features are often referred to as “conversion features” in the loan documents, they generally do not expose the lender to changes in the fair value of the company’s stock. Therefore, they should be evaluated as redemption functions and not as conversion functions. When a discount of more than 10% to the conversion price is offered, there is often a significant premium that triggers derivative accounting.
A real conversion option must also be evaluated; However, these generally do not need to be accounted for as embedded derivatives as they are gross-settled in shares of private companies that cannot be readily converted into cash.
Useful conversion considerations
In addition, if the issuer has not adopted ASU 2020-06, it must consider whether to separate the conversion function under the beneficial conversion function model. To learn more about ASU 2020-06, read the article titled “Why consider early adoption of ASU 2020-06??”
Effective Interest Considerations
As mentioned earlier, bridging loans often have a lower contractual interest rate where the investor is compensated with the discounted conversion rate. Take the example above, where the investor has effectively received a 20% rebate on the next stock round. If the bridging charge pays a coupon rate of 5% and the expected life is one year, the effective yield is 25% (5% accrued interest and 20% from the discounted conversion).
ASC 835-30 describes the total amount of interest over the life of a cash advance, measured as the difference between the actual amount of cash the borrower receives and the agreed total amount to be repaid to the lender. For this reason it may be appropriate to aggregate the redemption amount using the interest method unless the fair value option is chosen.
To further complicate this analysis, accounts under ASC 480, 815-15, and 835-30 overlap. Care should be taken not to double count the impact on earnings.
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As a Managing Director at Opportune LLP, Matt Smith assists companies with accounting for complex financial instruments under both US GAAP and IFRS. With over 15 years of customer service experience at Opportune and Ernst & Young, Matt has developed extensive knowledge and expertise in debt and equity finance, derivatives and hedging, equity-based payments and SEC reporting. He holds a bachelor’s degree in accounting from Oral Roberts University and is an Oklahoma Chartered Accountant.
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