Thinking of a Bridge Loan? The Pros, Cons, and Everything In Between

What is a Bridge Loan?

A bridge loan is short-term funding that startups and small businesses leverage to bridge funding gaps between fundraising rounds or significant financing events. It differs from a loan as it offers support during the transitional period to manage operational costs and for additional funding to support business planning and expansion.

Startup companies frequently encounter a period between receiving seed funding from venture capitalists and securing a substantial Series A round, which typically spans 6 to 18 months. Bridge loans enable these businesses to achieve milestones, validate their business strategies, and attract the necessary investors for the seed round and subsequent funding rounds.

Bridge loans typically last 6 months to 2 years. Repayment is expected once the business secures its next round of equity financing or a longer-term funding source. They offer flexibility in financial planning and help startups maintain operations while closing future funding rounds on their preferred timeline and terms.

Terms like "bridge financing," "bridge funding," and "interim financing for startups" are sometimes used interchangeably. The main point is that bridge financing provides quick access to short-term loans to bridge the financial gap for startups and boost their momentum.

Benefits of Bridge Loans for Startups

Bridge loans can provide benefits to startups needing short-term financing between funding rounds. Here are some benefits of bridge loans for startups:

Provides the Necessary Cash Flow to Continue Operations

A significant benefit of a bridge loan is it offers support to sustain and grow a startup. These funds can be used for employee salaries, rent, inventory acquisition, marketing initiatives, and daily operational needs. Numerous startups might have to simmer down operations without this short-term bridge loan amount or significantly reduce their growth pace.

Bridge loans help to buy the struggling startup some more time. This extra runway allows the startup to reach the next milestone or funding round while lowering the risks of running into financial trouble or prematurely running out of cash. The primary goal of a bridge loan is to keep the startup financially afloat through the temporary fundraising gap.

Gives Startups Flexibility in Fundraising Efforts

In addition to immediate cash flow, equity bridge financing and loans provide startups with flexibility regarding the timing and terms of their next funding round. Fundraising often takes longer than expected, and bridge financing means the startup isn't forced to accept undesirable terms only to survive another few months.

With the runway from a bridge loan, startups can shop around when raising funds, command leverage in negotiations, and find the best long-term fit investors. This flexibility is invaluable and helps startups raise capital on their terms rather than out of desperation.

Disadvantages of Bridge Loans for Startups

Bridge loans can come with several drawbacks that startups should consider carefully before securing this type of debt financing:

• Higher Interest Rates - Because of their risky nature, bridge loans have higher interest rates than traditional bank loans. The interest rates can range from 10% to 16% but could even go higher.
• Closing Costs - When you get a bridge loan you typically have to cover closing expenses. These expenses often add up to around 2% to 5% of the loan amount. You need to pay these closing costs upfront which can reduce the money you receive from the loan.
• Repayment Challenges - If the upcoming round of funding is delayed, startups might face difficulties repaying the bridge loan. Startups must repay the loan and interest, potentially causing cash flow or liquidity issues. Having bridge loans could also indicate instability to prospective investors.

While bridge loans provide an influx of capital, startups, and future investors should weigh the risks carefully. The high cost of capital and repayment challenges can become serious burdens if not planned properly. Bridge loans are best used sparingly, typically short term, and only when necessary.

Types of Bridge Loans

Bridge loans come with different structures, each with its pros and cons for startups. The three main types of bridge loans are:

Convertible Notes

• A convertible note is a loan that converts into equity in the next funding round
• No interest payments are required on convertible notes
• The loan converts to equity at a discount or valuation cap set in the note
• Convertible notes allow startups to defer valuation negotiations until the next funding round
• They are simple and fast for startups to implement compared to equity rounds
• Convertible notes do carry more risk for investors than loans repaid in cash

Term Loans

• Term loans are traditional loans repaid with interest by a set closing date
• They can be repaid either during the next funding round or per an amortization schedule
• Term loans require making monthly or quarterly interest payments
• The loan principal balance must be paid back in full, eventually
• Term loans allow startups to keep debt off their cap table
• However, they create cash flow pressure to make interest payments

Lines of Credit

• Startups can access a line of credit up to a set limit
• Interest is paid only on the amount drawn, not the full limit
• Lines of credit provide maximum flexibility for startups
• Startups can draw what they need when they need it
• But lines of credit usually require a personal guarantee and a high credit score
• It can be easy to become too dependent on credit lines without financial discipline, which can be very risky

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Qualifying for a Bridge Loan

When looking for a bridge loan for your business, ask the right questions to understand the loan terms, costs, and eligibility criteria. Here are a few  things that can improve your chances of securing debt from bridge loan providers:

• Recent financial statements - Make sure your recent financial documents cover all the essentials; income statement, balance sheet, cash flow statement, and statement of owners equity. These documents must be accurate and reflect the current state of your startup.
• Projections and assumptions - Along with historical financials, lenders want to see future revenue, expenses, and cash flow projections. Provide detailed assumptions and reasoning behind your projections.
• Progress, traction, metrics - Demonstrate proof that your startup is progressing successfully by showcasing user growth, improving conversion rates, new partnerships, and other indicators of progress. These aspects indicate that you are effectively carrying out your plans.
• Fundraising materials - Review any pitch decks, executive summaries, or materials you've used for past or upcoming fundraising rounds. This gives insight into your strategy for securing future financing.
• Next round funding details - It would be helpful to know the target fundraising amount, details of potential investors, and an estimated timeline for finalizing the round.
• Personal guarantee - Lenders typically ask startup founders to provide a guarantee to secure the loan, putting the founder's assets at risk in case the startup fails to repay the bridge loan.

In order to improve your likelihood of securing a bridge loan it is crucial to present an overview of your startups performance, financial status and upcoming fundraising strategies. Remember that bridge loans come with criteria as they are considered riskier than funding options.

Alternatives to Bridge Loans

Before opting for bridge round loans, startups should explore funding sources rather than immediately resorting to debt for short-term financing. Here are some alternatives to bridge rounds:

Crowdfunding

Websites such as Kickstarter and Indiegogo offer companies a platform to seek backing from individuals through crowdfunding. This can validate your product concept and cultivate a customer base. Crowdfunding is most effective for consumer goods or initiatives with a captivating narrative. Amounts raised are typically under $1 million.

Angel Investors

Angel investors are high-net-worth individuals who finance startups in exchange for equity. They invest their own money and often take an active mentorship role. Angels tend to fund earlier-stage companies than VCs. Angel financing rounds are usually under $1 million.

Venture Capital

VC firms raise a large amount of funding and invest in high-growth startups. In exchange, they require a stake and say in the company. VC funding usually ranges from $2-$10 million. VCs offer valuable advice and connections, but getting accepted into a top VC firm is extremely competitive.

Bank Loans

Traditional banks can offer loans to finance startups without taking any equity in exchange. However, startups often lack the necessary collateral, credit history, and financials to qualify for other loans. Government-backed small business loans are more accessible but max out at around $5 million.

The alternatives above allow startups to raise capital without taking on short-term debt. However, each option has tradeoffs to weigh. Assess your startup journey, specific funding needs and trajectory to pick the best financing path. Bridge financing options can address needs although it's important to remember that a temporary loan isn't always the sole remedy.

When Do Bridge Loans Make Sense?

Bridge financing is ideal for new businesses expecting a funding round in the next 6 to 18 months and requiring funds to sustain growth until the next permanent funding round is closed. Bridge loans are particularly beneficial under the following conditions:

• A clear strategy and schedule should be in place for the institutional funding round, such as Series A or beyond, with a target closing window of 6 to 18 months to match the bridge loan term.
• You have projected a cash shortfall between now and the expected close of your next round. If not covered by a bridge loan or other financing, this shortfall would force you to slow growth plans or even shutter operations.
• If you're running low on cash and need to keep up with tasks such as hiring engineers, marketing, expanding office space, and buying equipment, applying for a bridge loan may become crucial. Winding down growth initiatives in such a vulnerable phase of the business can have more than anticipated consequences.
• You want flexibility in how much you raise in the next round and autonomy in selecting investors. You'd rather not take the first offer that comes along. A bridge loan provides this much-needed flexibility.
• You want to minimize dilution at this stage by avoiding an emergency inside the "party round" at a low valuation or unfavorable terms. A bridge loan prevents dilution.
• Your startup is still pre-revenue or has minimal revenue. You may also find it hard to qualify for traditional financing, but bridge loans may be available for pre-revenue companies.

A bridge loan makes sense when you cannot afford to slow your startup's rapid growth and market expansion trajectory but need time and flexibility to raise money in a proper funding round with outside investors. The bridge loan buys you that necessary time and runway before raising money.

Questions to Ask Your Bridge Loan Provider

What is the interest rate, and how is it calculated?

• Interest rates on bridge loans tend to be higher than those on conventional bank loans, ranging from 10% to 15% on average. Make sure to ask if the rate is fixed or variable.
• Also, understand how interest accrues—some lenders calculate interest on the original principal, while others compound interest on monthly payments.

What additional fees, cover fees or closing costs are involved?

• Lenders may charge origination fees, application fees, or closing costs in addition to interest. Ask for a detailed breakdown of all fees.
• The lower the fees, the better the deal. They should be around 2-5% of the total loan amount.

What are the loan terms and repayment schedule?

• Numerous lenders may prefer to receive interest payments at the beginning followed by a principal payment when the loan matures. Inquire about options.

What are the qualifications and required collateral?

• Lenders will want a viable business model and path to the next funding round. Be ready to provide financials, projections, and other relevant details.
• Most providers require collateral, such as business assets, equipment, real estate, or an owner's personal guarantee. Know what collateral is expected.

Asking any questions from the beginning can help you understand the expenses and conditions better. Before committing, make sure the loan aligns with your startup’s needs and capabilities.

Conclusion: Bridge Loans Can Provide Critical Short-Term Runway

A bridge loan could be a choice for new businesses facing temporary cash flow issues between major funding rounds or cycles. When used thoughtfully, bridge loans provide startup founders with the freedom and time needed to secure their next funding round under certain agreed-upon conditions rather than being under pressure that stems from traditional banking loans.

Bridge loans come with real risks and costs, so startups should not rely on them as an ongoing crutch. The ideal scenario is for venture capital investors to use startup bridge loan financing only when absolutely necessary during temporary fundraising slowdowns. With reasonable expectations set, bridge loans can provide startups with the financial lifeline they need to survive and thrive in the next stages of growth.

Entrepreneurs should carefully evaluate their situation before committing to a full bridge loan financing amount. Seek advice from financial advisors and mentors in their network. Consult with experts or experienced individuals in your circle for guidance. Also, ensure you have a solid strategy and schedule in place to secure your next round of funding. By staying focused and well-informed, founders can use bridge loans as a resource to steer their growing startups through temporary obstacles effectively.

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