A Burger Today: Spotify’s Bridge Loan to Nowhere is All the Rage

“D” is for “desperate.”  And “debt.”  According to the Wall Street Journal:

Swedish music-streaming company Spotify AB has scheduled a series of investor meetings in an effort to raise about half a billion dollars through a convertible bond issue, a person familiar with the matter said Wednesday.

Spotify is eager to have financial firepower at hand should consolidation opportunities arise in the industry, according to the person. The issue won’t necessarily be a prelude to a stock-market listing of the privately held company, the person said.

The Financial Times tell us:

Swedish newspaper Svenska Dagbladet, which first reported the planned funding round, said that the loans would pay an annual interest rate of 4 per cent. In addition, they would convert into equity at a 17.5 per cent discount to Spotify’s share price if the company goes public in the next year.

This financial structure would guarantee lenders hefty returns if Spotify completes a long-mooted initial public offering, whatever the value of its equity. If Spotify does not float within a year, the discount at which the loan converts to equity will increase by 2.5 percentage points every six months.

Spotify’s decision to raise funds by issuing debt rather than equity comes as investors have become increasingly worried that the valuations of many private technology companies are unsustainably high.

Spotify declined to comment on the planned funding round, or why it was seeking to raise $500m so soon after its previous big fundraising.

The FT reports that Deezer pulled its planned IPO on the Paris exchange and also went for the bonds instead:

Deezer, the music streaming service that last year abandoned an attempt to raise €300m in an initial public offering, has secured a €100m cash injection from its existing investors led by Len Blavatnik’s Access Industries.  [Mr. Blavatnik is also a major investor in Warner Music Group.]

The Paris-based company, which ranks as the third-biggest music streaming service by subscriber numbers after Spotify and Apple Music, cancelled its IPO in October after failing to convince stock market investors that it justified a valuation of as much as €1.1bn.

And then there’s Pandora.  Zack’s says in “Pandora Shares Tumble on Convertible Debt Offering“:

[Pandora] will be offering $300 million aggregate principal amount of convertible senior notes due 2020. Morgan Stanley & Co. LLC, acting as the sole book runner for the offering, will be granted a 30 day option to purchase another $45 million worth of notes.

Pandora expects to use some of net proceeds to compensate the “capped call transactions” costs and the remaining for general corporate purposes.

What is very likely common to all three of these companies is that they don’t have Apple’s bank account which itself is probably equivalent to the GNP of many countries.  It’s also likely that all three companies are out of favor with equity investors and bankers.  And as we have heard recently, those guys aren’t babies.  If you need their money, bankers will get their pound of flesh and then some.

Why do I think this?  You mean, aside from the fact that the fremium business model stinks?  In Pandora’s case, they have already had two bites at the equity apple–so to speak–and evidently are not getting a third.  Deezer’s IPO is a bust and it looks like Spotify is staring down the wrong end of a down round.  All are losing money.  Eventually efficient markets figure this stuff out, particularly lately (h/t to Leonardo Fibonacci).

So what to do?

You could cut back on spending and overhead (see my analysis of Pandora’s financials).  But in the heated bidet world, that’s not happening.  Debt!  Debt is the key.

So, if you’ve been reading along, you’ll have noticed that a new financing instrument is all the rage in the “smarter than thou” world of disruptive streaming:  Convertible debt.

I’d Gladly Pay You On Tuesday for a Burger Today

In case you’re not familiar with convertible debt, there’s a few typical components to the debt contracts that are both customary and revealing.  First, realize that these instruments are a hybrid of a loan and a stock offering.  On the loan part, there’s an interest rate and a maturity date, but the interest rate is usually lower than a junk bond because of the stock part.  The lower interest rate is justified by a stock “sweetener” that allows the holder to convert all or part of the principle and accrued interest into stock–hence the “convertible debt” monicker.

The accrued interest part is important–for private company convertible loans, the interest is sometimes rolled into a balloon payment at the maturity date or when the loan converts.  Why?  Because the debtor company needs the cash to run the company, not to make interest payments to a special class of convertible debt holders.  (For those reading along, this could produce a cross-over question with bankruptcy and secured transactions if the payment of interest to the debt holders constitutes a voidable preference in an otherwise insolvent company.  But leave that for now.  The establishment narrative prohibits using “insolvent” and “Spotify” in the same sentence.)

Convertible debt, or “bridge loans”, are common in private company financings when a venture-backed company is running out of money but doesn’t want to, or is not able to, conduct its next round of financing.  The debt holders are sometimes insiders who invested in a prior round and intend to invest in the next round–if it ever happens–but do not want to set the valuation for the future round.

Let me say that again–bridge loans are often used as a way to get cash in the door to keep the company running when it’s not able to get the valuation it wants from investors.  This is particularly true if the valuation is less than the valuation in its last round of funding also called a “down round.”  Venture backed companies avoid down rounds like the plague because it usually results in very nasty things happening to all prior investors and employee stock options or employee stock holders.  This is especially true if the senior holders have aggressive anti-dilution protection that issues new shares to them.

Here’s an example.  Spiffy, a venture backed startup, has had three rounds of venture financing in which it issued convertible preferred stock.  Venture rounds are usually designated by letters as in A round, B round and C round corresponding to Preferred A, Preferred B and Preferred C.  In Spiffy’s case, each round of A, B and C preferred stock was issued at progressively higher valuations.  (Most venture financing valuations are essentially negotiated, i.e., made up, and are determined by the investor and Spiffy’s board of directors with virtually no oversight from anyone.)

Spiffy is planning on “going public,” i.e., registering its shares in a full commitment underwritten initial public offering on a major stock exchange (probably NASDAQ), commonly called an “IPO.”  Unfortunately, it turns out that Spiffy’s management are actually incompetent and the company got sued in two different class actions that call into question whether Spiffy can continue to suck air long enough to put on some lipstick and stockings and get shoved out the door to the great profit of Spiffy executives and investors.

What should Spiffy do?  One thing it can do is go to its insiders–who are highly incented to play ball–and ask them to make bridge loans.  Why?  Because a bridge loan with a principle that is convertible into shares at some future event does not require a current valuation the way a new round of preferred stock would.  That valuation will only occur when the future event comes to pass.  Examples of a future event would be an IPO or the next round of equity financing (the “D round” in this case).

This gives Spiffy some time–usually not very long, i.e., months not years–to get its valuation up and either line up the underwriting syndicate for its IPO or sell shares in an up round.

That’s right–Spiffy would gladly pay on Tuesday for a burger today.  This is not complicated.

Bridges to Nowhere

Here’s another thing–bridge loans are typically not nine figure sums.  They may be millions but usually are much less.  If I had to guess, I would guess that the terms of Spotify’s loans–which appear to be pending, as in not closed–are going to get a lot sweeter for the lenders.  As long as the convert event is not a down round it may not be that bad for investors, although it will almost certainly be highly dilutive for employees.

The problem with bridge loan investors is that one bridge can turn into another if the burn rate stays high.  Remember this part from the FT?

Spotify’s decision to raise funds by issuing debt rather than equity comes as investors have become increasingly worried that the valuations of many private technology companies are unsustainably high.

Once the bubble starts to burst, you can just forget the ever higher valuations.  Like Southern California real estate, what goes up must come down no matter what the streaming boosters or California real estate brokers would have you believe.

Just like people rushing around trying to dump Spotify stock in the secondary market in a desperate search for the greater fool.

And of course we all know who will be left holding the bag, right?

Artists and songwriters who watched a perfectly good business destroyed.