As your company continues to grow, various types of financing options will become available and necessary. Many factors, including your company’s strategic goals, will influence your decisions about what types of financing to use. These financing decisions can have a profound effect on whether the company will succeed or fail. This article will identify the situations in which a bridge loan might be needed for a company, define what a bridge is, and discuss certain features that make bridge loans especially beneficial for startup companies.
A bridge loan is a convertible loan that allows companies, in between funding rounds, to access funds quickly if needed. This type of loan is called a bridge loan because its purpose is to “bridge the gap” between the companies major funding rounds by providing quick funding. The key benefits of a bridge loan are its convertibility feature as well as the speed at which a company can acquire this kind of financing. In the right circumstances, the function of a bridge loan is vital for businesses.
Financing Your Business
Startups will generally have many rounds of financing that allow them to generate funds as they grow to the stage of an IPO. The company can be funded at each stage by both debt and equity financing. These rounds of funding serve as the springboard to continue developing since the startup’s cash collections from customers may not be sufficient to cover operating and investing cash outflows. The first round, where companies approach smaller investors to build up interest in the business, is seed funding. After sufficient seed funding has been acquired, the company graduates to equity rounds. Included in the equity rounds are series A, B, C, and so forth. These rounds include investing groups and individuals as the company builds up toward an initial public offering. Investors expect the company’s continued growth through all levels of financing to qualify for both the equity and debt financing that a startup company needs. Investors could be private individuals, groups, or venture capitalists aiming to participate in the increase in value of your company as it develops and grows. Bridge loans tend to be preferred by investors in certain circumstances discussed below due to their convertibility. To learn more about the stages of financing, see our article, The Stages of Startup Financing.
Cash Burn Rate
Young, growing startup companies often spend more cash than they receive from selling their services or products. The amount of cash that is used in operations and expansion each period is known as the cash burn rate. This number helps project the future capabilities of the company, as well as how feasible it is for the startup to reach the expected milestones given the amount of cash remaining from the previous funding round. Some activities require more cash than others, and it is important to combine the cash burn rate with the existing level of available cash to project short-term funding needs.
The cash burn rate can be calculated by taking the amount of operating and investing cash inflows minus the corresponding outflows over the course of the period, divided by the length of the period of measurement. For example, if ZipZ Co. receives cash of $50,000 per month and spends $110,000 per month, they have a burn rate of $60,000 per month or $15,000 a week.
With the help of this cash burn rate, wise companies can forecast their cash needs in the future and survive to reach each subsequent round of funding. Ultimately, many companies fail. But there are different moments when they are most susceptible. Fifty percent of companies fail during the period after receiving Seed A funding and before Seed B funding.1 This failure can occur for many specific reasons, but in the final analysis the company just runs out of cash. Between funding rounds, if growth slows or immediate funding is needed, it becomes difficult to raise cash in the following rounds. These dips in cash or profitability could be a warning sign of increased risk to the possible investors. A bridge loan can be a vital tool for a fast response to these cash flow difficulties.
Startup Loan Risk
An accurate forecast of cash burn rate is important for young businesses, as the process to obtain debt or equity financing is often lengthy. Acquiring these types of permanent funding can take months to arrange. In short-term situations, it can be difficult to raise enough capital via traditional and private loans. Banks and institutional lenders take on higher risk when lending to younger companies as there is a significant chance of default. The risky nature of an early business requires that a prudent loan approval process take months—months that might not be available when the startup needs the cash now. And the process for obtaining equity financing can take even longer.
Whether by poor cash flow forecasting, emergency, or just unexpected business problems, there can arise short-term financing needs in between long-term financing rounds. To entice lenders into making these risky short-term loans, the lender must expect compensation and protections that tend to be rather expensive and restricting for a startup company. This compensation and these protections can be in the form of higher interest payments and strict loan covenants. These emergency, short-term loans can solve temporary cash problems, but the increased interest payments will also increase the cash burn rate during the life of the loan.
Bridge loans help solve a variety of short-term cash flow problems because they can be obtained quickly. Because bridge loans are structured as short-term financing—with an interest rate typically lower than the rate on long-term loans—there must be another motivation present for the lender, otherwise lenders have little to no incentive to make the bridge loan to the risky startup company.
To compensate the lender, these bridge loans offer the option to convert the loans into equity. The interest rate on a bridge loan is generally lower because the lender is compensated by receiving an option to obtain a stake in the business, usually structured to allow the investor to receive shares in the next round of financing at a discount. These bridge loans are also often structured as interest-only loans, with no regular payment of principal. A bridge loan can also be structured to include a lender option to convert the short-term loan into a long-term loan, at a higher interest rate, if the borrower does not pay off the loan by the end of the bridge loan period.2
These conversion features often allow bridge loans to serve as an advance on future financing, thanks to investors who expect to finance the next round of equity financing by advancing some of that financing in the form of bridge loans. This is done by providing short-term loans (generally with a maturity of around one year) that will be converted to equity shares in the next round.
The key benefit of bridge loans to the provider of funds is the convertibility in tandem with the short-term nature. The conversion feature allows an investor, who is interested in contributing to the next equity funding round, to secure their investment at a specific price beforehand. These investors can provide a short-term loan but at the same time secure their stake in the company.
If the company uses a bridge loan correctly, it can allow them to continue to grow and overcome short-term cash flow hurdles they encounter. The bridge loan is helpful because of its flexibility. A bridge loan has a short processing time and lower interest rate, and a convertible bridge loan brings in a potential investor who was already intending to invest in the next round. With a typically shorter processing period, bridge loans allow for quick access to funds instead of waiting during the longer process typically associated with obtaining long-term debt.
Because bridge loan recipients typically are startup companies in need of cash now, there are always risks and disadvantages that must be considered. Investors may want to mitigate their higher inherent risk through loan covenants, but strict covenants can cripple the needed flexibility of a startup company. In addition, if the decision to obtain a convertible bridge loan is made without careful analysis, the startup company could end up giving away too much equity or might not receive enough cash to make it to the next permanent funding round. The danger of overly hasty analysis is significant because one of the hallmarks of a bridge loan is the speed at which it can be acquired. Careless analysis could result in a short-term bridge loan that then must be carried forward as a long-term loan with a higher interest rate which can put even more strain on the struggling startup company.
Obtaining a bridge loan is a short-term decision by a startup company, and the focus is on the short-term consequences. But when making these short-term decisions, the startup must be careful not to forget about the long-term viability of the company. Obtaining a bridge loan should be part of a careful forecasting, planning, and projecting exercise to give the startup company a sustainable capital structure.
Marsh & McLennan Companies Inc. is a professional services firm located in New York City. They are currently the largest insurance broker in the United States. The company was interested in acquiring JLT Group, a European insurance broker. Due to the high price tag of £4.3 billion ($5.6 billion), the company approached Goldman Sachs to provide a bridge loan. The bridge loan agreement 3 included most of the loan covenant restrictions that would normally be associated with such a loan. These covenants include limits on debt ratios and interest-to-income ratios, and further rules about future allowable debt. Because March & McLennan were buying out a UK company, they were required by the UK Takeover Codes to take out a large loan specifically for this situation. March & McLennan is a large organization, not a startup, but this situation demonstrates the helpful effect a short-term bridge loan can have on the financial flexibility of a company.
In the right situation, bridge loans can be a lifesaver for a company, while at the same time allowing it to follow its long-term growth strategy. Due to the loan covenants and convertibility option often present, bridge loans allow for a lower interest payment and a faster loan processing period. Projecting future cash flows when dealing with bridge financing is vital. As bridge loans tend to be expensive, comparison between the risks and benefits will allow a company to make the most of the cash influx while managing the costs.