What are bridge loans?
Bridge loans, also known as “bridge financing” are typically a type of short-term loan taken out for a period of 6 to 12 month for the purpose of “holding-over” a company until they can secure longer-term financing (such as an equity round) or when they expect to receive significant cash inflows from a signed deal.
What are bridge loans typically used for?
Startups often leverage bridge loans to solve a variety of short-term cash flow and working capital related problems since they can be obtained quickly. Common uses for bridge loans include funding the day-day operating expenses, such as payroll and rent, and satisfying other short-term debt obligations. Bridge loans are also used by startups to sustain their growth trajectories by spending on sales and marketing or accelerating product development to hit certain milestones and increase their valuation.
What are the advantages and disadvantages of bridge loans?
The main benefits of a bridge loan include: a faster spin up period (days instead of months) and a lower interest rate (compared to long-term loans) because of the shorter payback period.
The main disadvantages of a bridge loan include: a fixed payback period (once the term is locked it cannot be changed), shorter payback period (shorter payback periods typically only align with and therefore deployed for short term goals) and conversion rights for investors (investors may have the ability to convert the loan into equity shares in the next round).
In what scenario would a bridge loan be useful?
Consider the following example. A startup is in the process of raising its Series A. It has some revenue, but not enough for revenue based financing, venture debt, or traditional business loans. It needs capital to fund operations from now until the Series A close, which could take 2-3 months, so it’s evaluating potential capital providers. Following the Series A, the startup will be able to satisfy the loan obligation, so it explores the bridge loan route.
The startup receives $500k in funding, with an 8% APR interest rate. Over the next three months, it satisfies the fixed monthly payments, closes the Series A and the lender converts the remaining balance into an equity position. In this instance, the bridge loan worked exactly as expected by providing operating capital to help “bridge” the gap between the start and close of the funding round.
In what situations would taking a bridge loan not be advised?
- If in a dire financial state - if you’re on the brink of bankruptcy, it may not be a good idea to take on additional debt (even if the board approves it). In the event of default, the debt holders will receive preferred liquidation rights and it will not end well for your current shareholders. Additionally, if you are in dire need of cash, some lenders may take advantage of the situation and provide one-sided provisions that can completely ruin your corporate governance.
- If you do not know how much capital you need or what you will use it for - taking a loan for more than you need, or for purposes that you have not yet determined is not an efficient or effective use of capital. Rather than guessing how much capital you need, consider putting together a forecast, with certain target thresholds so you can justify your need for the capital. The use of funds should align with your goals in terms of dollar amounts and executable timelines.
What’s the difference between bridge loans, venture debt and regular loans from a bank?
Typically loans from a bank are more conservative in terms of size and pricing for more mature businesses that tend to be cash flow positive, but may require additional collateral or personal guarantees from the founding team. Venture debt typically comes with contractual provisions such as warrant coverage and a 2-3x liquidation preference, but the startup is usually growing significantly in terms of revenue and has already closed at least a Series A with the next Series Round (B, C, etc..) “likely” in the next 12 - 24 months. In both situations, there will likely be: covenants tying loan amounts drawn to performance milestones, a lien on all assets, and the time to get funding can be lengthy (2 - 4 months from first conversation to close). With bridge loans, funding is provided in a matter of weeks, there may not be a lien on all assets (in particular IP), and typically don’t come with the same restrictions mentioned above.
Should I call it an extension round or a bridge loan?
In Silicon Valley, bridge loans may sometimes come with a negative connotation. Some equity investors associate bridge loans with poor operating performance or mismanagement of capital, but this isn’t always the case. Sometimes startups are growing so fast that they have no other choice than to take on bridge loans while they’re waiting for their equity round to close or waiting for cash inflows from their customer base to become more predictable. Some VCs have realized this and have proactively offered bridge financing to startups in such a position.
A note on defining the type of financing or naming: consider positioning it as an extension round to your board, rather than a bridge loan. Focus specifically on what the need for the capital is, your plan for its deployment, and what milestones your startup will achieve with this funding. Approaching your capital providers this way, will make the “sour pill” a bit easier to swallow.
How should I structure my bridge loans?
Typically you should first target your existing investors to raise a bridge. If your “insiders” aren’t willing to provide enough, consider asking for introductions to other firms who provide bridge loans. Because bridge loans are often needed quickly, it is typically structured as convertible debt with a valuation cap or a discount rate to the next priced equity round.
As with most forms of financing, the terms and contractual provisions are negotiable. A startup will have more “leverage” for better terms if the funding request is carefully planned with a clear path to growth milestones. Before you sign a term sheet it is imperative that you understand the rights that your potential investors expect —do not agree to terms that you do not understand or have not discussed with your council.
What are the pitfalls to avoid when raising capital through bridge loans?
- Having illegitimate reasons for raising the bridge - depending upon the rights that your board has, you may be required to get their approval prior to raising a bridge. If you cannot justify why you need the capital and your plans for deployment, it is very likely that your proposal will be vetoed.
- Offering lower bridge valuation - If you lower your valuation for the purposes of raising a bridge, know that it may come back to haunt you. If future investors can’t get the same favorable terms, they may choose to pull out of the round completely. There is a sweet spot in terms of paying higher/lower interest rate payments versus giving up ownership at a higher/lower valuation (all while not constraining your startup with burdensome expenses). Planning and building out realistic projections will be key during negotiations, as it signals a more pragmatic leadership team that can simply explain how the company will grow.
- Not understanding the contractual provisions - If you’re in a sticky financial situation and are in need of funding, the likelihood that you receive an unfavorable funding agreement is high. Review through all of the contractual provisions with your council prior to signing anything.
Our thoughts on bridge loans
While bridge loans are useful for startups in certain situations, a more founder-friendly alternative for companies with growing revenues is revenue based financing, which enables companies to convert their future revenues into upfront capital. Unlike bridge loans, there is no convertible equity component, the total cost of capital is known upfront, and there is no recourse in the event of default. With revenue based financing, founders can access the capital they need today, without any of the drawbacks of other financing tools.