Bridge Financing: Everything You Need To Know
Bridge financing is when investors invest in a startup with a short-term loan for a round of funding, on the basis that the loan will be returned. 8 min read
What Is Bridge Financing?
Bridge financing is when investors invest in a startup business with a short term loan in order to help it reach the next round of funding, on the basis that they will receive their money back. Basically, it is used to 'bridge' the gap between investments to keep a startup company afloat.
Startups use bridge financing or a 'bridge round' in order to help them get to a significant round of funding such as an equity funding (like a venture capital round) or the sale of the company.
The initial investors would receive a promissory note documenting their bridge investment. In this promissory note, the startup would promise to repay the lenders, sometimes with interest
For example, if you raised $500,000 in round A funding, but needed another $500,000 and you were projected to raise $2,000,000 in round B funding, you could use a bridge loan of $500,000 until the round B funding was complete, paying back $500,000 from the $2,000,000.
What Is a Startup?
A startup company is a new business which is potentially fast growing and aims to fill a hole in the marketplace by developing and offering a new and unique product, process or service but is still overcoming problems.
Startup companies need to receive various types of funding in order to rapidly develop a business from their initial business model that they can grow and build up.
Bridge Financing Becoming Convertible Debt
Some bridge financing promissory notes take the form of convertible debt. This means that instead of being paid back in money, investors will be paid back with the equivalent of that money converted to equity stock upon maturity.
Other 'equity-kickers' such as valuation caps, discounts, and warrants can also be included.
- Valuation Caps
Valuation Caps are put in place to protect investors from unrecognized gains in company value during a bridge financing period that would shrink their ownership. E.g. A $100,000 bridge loan would guarantee the investor 20 percent of the business if there was a $500,000 valuation cap.
A discount included in a bridge financing deal would be something similar to a discounted price on shares in future rounds of financing. If a 20 percent discount was applied to the same investor as before, who invested $100,000 they would be able to buy 125,000 shares in future financing loans.
A warrant is the right to purchase shares at a set price in future financing rounds. The same $100,000 bridge loan with a 20 percent warrant coverage would enable the investor to buy $20,000 worth of stock at the next round's prices at any point in the future.
Sometimes convertible debt is used to describe a bridge financing where the investor is paid with money.
Why is Bridge Financing for Startups Important?
There are several reasons why bridge financing might be important to a startup.
- Looking to Go Public – A startup might be looking to go public with its products/services gaining some popularity. Receiving a bridge startup here would allow them to do the following,
- Mergers and acquisitions
- Price reductions to drive out competitors
- Financing towards an initial public offering
- Achieve Targets – Some startups may have targets or milestones to hit that will enable them to receive more funding from investors. Receiving bridge financing might allow them to achieve those targets or milestones.
- Avoid Valuing the Company – Convertible notes value the company later. This is because they convert into equity at the next round of funding at a discount to per-share price investors pay in the next round. This means that a company can value its stock at a later date after receiving bridge financing.
Bridge financing can, and has, been used at each of the funding rounds that a startup would ordinarily go through. These are as follows.
- Seed Funding – Typically known as the 'friends and family' round because it's usually people known to the business owner who provide the initial investment. But, Seed funding can also come from someone not known to the founder called an 'Angel Investor'. Seed Capital is often given in exchange for a percentage of the equity of the business, usually 20 percent or less, with funds raised usually between $250,000 and $2,000,000.
- Round A Funding – This is the stage that venture capital firms usually get involved. It is when startups have a strong idea about their business and product and may have even launched it commercially. The Round A funding is typically used to establish a product in the market and take the business to the next level, or to make up the shortfall of the startup not yet being profitable. Funds raised usually fall between $2 and $15 million.
- Round B Funding – The startup has established itself but needs to expand, either with staff growth, new markets or acquisitions
- Debt Funding – When a startup is fully established it can raise money through a loan or debt that it will pay back, such as venture debt, or lines of credit from a bank.
- Mezzanine Financing and Bridge Loans – Typically the last round of funding where extra funds are acquired in bridge financing loans in the run uprun-up IPO, acquisition, management buyout, or leveraged buyout. This is usually short-term debt with the proceeds of the IPO or buyout paying it back.
- Leveraged Buyout (LBO) – A Leveraged Buyout is the purchase of a company with a significant amount of borrowed money in the form of bonds or loans instead of cash. Usually the assets of the business being purchased are used as leverage and collateral for the loan used to purchase it.
- Initial Public Offering (IPO) – An Initial Public Offering is when the shares of a company are sold on a public stock exchange where anyone can invest in the business. IPO opening stock prices are usually set with the help of investment bankers who help sell the shares.
Reasons to Consider Not Using Bridge Financing as a Startup
Using a bridge loan is not without risks for both the investor and the startup:
Risks for Startups
- Not good if desperate for money - Often, a company's board of directors or executives can make bad decisions when it comes to receiving bridge financing loans, especially in times where the company is in dire need for capital.
- Difficult to decide how much is needed – A startup will need to decide how much it actually needs in a bridge loan, and if it gets it wrong it risks giving away too much of the company's assets or not receiving enough funding to make it to the next funding round.
- Red Flag for other investors – Sometimes, but not always, a bridge loan is a sign that a company is struggling and that the investor doesn't want to write-off their initial investment yet. This means that on occasion other investors will look at a company that has received a bridge loan and be put off from investing.
- Becoming Overcautious - Sometimes the pressure of running a struggling startup having accepted a short-term bridge loan can cause company decisions to over-cautious and decisions to be made that are bad for the company in the long term.
Risks for Investors
- Deciding how much to spend – Investors have the same problem as startups in choosing how much to invest. They want to give enough money to prevent the startup going bankrupt, but at the same time they don't want to invest too much in a startup if it does in fact fail to generate enough money to pay them back.
- Loss of Investment – Bridge loans represent significant risk to an investor's investment. Usually a note purchase agreement is given to a startup from the investor in which the investor states they are aware they might lose all of their money.
Historically, bridge loans made by angel investors to startups do not end up successful . The loss rate is typically high, and the return on the successful ones is usually not big enough to justify the risk.
Reasons to consider using Bridge Financing as a Startup
There are several benefits to bridge financing for startups and investors as well:
Benefits to Startups
- Prolong life of company – If a startup is struggling financially a bridge loan represents a suitable short-term loan that can help prolong the life of the company, allowing them a chance to turn things around.
- Make a company more valuable – I f a startup is doing well and expanding rapidly a bridge-loan can give it the funds to make that vital next time in terms of expansion and growth allowing existing investors to profit.
- Get a startup off of the ground – These days a bridge loan is being used more and more to help get a startup off of the ground, providing the investment needed at the 'seed' stage of the business to get it started.
- Ease of Use – It is much easier for startup to receive a bridge loan than to work out the value of their business and how much an investor's equity stake would be.
Benefits to Investors
- Small Investments – Usually a bridge loan will be a fairly small investment in the grand scheme of things, but when it can be converted into equity it could result in a big pay off.
- Options are open – Bridge loans allow an investor the choice of ending their engagement with a company once they've received their money back, or continuing to invest.
Several tech startups such as Facebook, Twitter, and Yelp were only possible after years of venture capital and bridge financing funding that fueled growth. Now these free apps and services have changed the way we live and the investors will have received a healthy return on their investment.
- Not getting the right size bridge loan – When making a bridge loan it is important that the right size loan is received. Otherwise a company will not be able to 'bridge' to the next transaction.
- Not doing enough to convince investors a bridge will result in a return – Investors will not make a 'bridge to nowhere' they need to be convinced that a startup has a plan in order to garner new investment and pay the bridge back.
Frequently Asked Questions
- What is a 'Go Shop' and 'No Shop'?
A 'Go Shop' or 'No Shop' is an agreement that a startup might have with an investor. If it is 'No Shop' the start will have agreed to solely negotiate any future funding with that specific investor for a period of time. If it is 'Go Shop' they will be allowed to 'shop around' for more, or better investments.
- What's the better way to handle the board?
It's better to handle transactions at an active board meeting rather than by unanimous written consent of the board members. This shows courts that the board members are actively behind the company's decisions.
- What interest rate might I pay on a bridge loan?
It depends on the current rate and whether or not the investor has a warrant coverage or discount. However, it's usually between 6 percent and 12 percent.
- What should the terms of bridge loan warrant coverage be?
A bridge loan warrant should have the following terms:
- It should be applicable in the next round of funding. E.G. if a company receives a bridge loan to 'bridge' between round A and round B funding, the warrant should be active for round B.
- The warrant coverage should be in connection with the note, using the following formula.
[number of shares issuable upon exercise of warrant] = [principal amount of loan] * [warrant coverage percentage] / [exercise price per share in the next round of financing]
So, 20 percent warrant coverage on a $500,000 bridge loan assuming that the next round price is $2.00/share would be: [50,000 shares] = [$500,000] * [0.20] / [$2.00]
- The price of purchasing the shares in the warrant should be the price per share in the next round of financing. Usually, it is fixed at the last round price.
- A warrant is usually valid for a period of three to seven years with five being fairly common.
- Warrants should expire when a startup is sold and should probably expire on an IPO. But the warrant holder will have the opportunity to purchase the shares before these events.
Need More Help With Bridge Financing For Startups?
If you need help with raising money for your startup and negotiating the best deal you can post your question or concern on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.