Bridge Loan Facts
When a small business like a startup needs capital fast, bridge financing is sometimes used to cover the gap between a current lack of funds and future incoming cash. There are specific advantages to these types of loans, but they also carry some risks. Entrepreneurs should understand the facts about bridge loans so they can make the best decision for funding their business ventures.
When to Get a Bridge Loan
A bridge loan is used in very specific circumstances related to long-term financing. When a company is waiting for more funding to come in, such as when a startup knows that it will close a round of financing in six months but needs cash right away in the short term, it may turn to bridge financing to cover expenses.
Understanding Types of Bridge Loans
There are different types of bridge notes that a company can take advantage of to acquire cash in the short term. In equity bridge loans, a company seeks out a venture capital firm to provide the cash needed in the short term, in exchange for a percentage of equity ownership in the company. This is known as convertible debt, because the debt is converted to company stock upon the loan’s maturity.
In this type of bridge financing, factors besides principal and interest come into play, so it’s essential that borrowers understand exactly how the financing works. There can be a warrant, which means the lenders can purchase stock shares at a pre-determined price in the future. There can also be a discounted price on future shares. In addition, lenders may seek to protect their investment by including a valuation cap. If the company makes unexpected gains prior to the conversion, investors are entitled to buy shares at a pre-determined capped percentage rather than the higher price resulting from the unexpected additional growth.
A debt bridge loan is given when a company wants to take out cash immediately to cover expenses based on cash it knows it has coming in the near future (for example, to cover the period of time between a bank loan approval and cash disbursal). Rates on this type of bridge financing can be prohibitive, however, so the business owner needs to be very strategic when choosing this option.
Bridge financing can be an excellent way for entrepreneurs to finance short-term expenses based on their expectation of future incoming cash flow. Understanding the specifics of this type of financing can help business owners make the best choice for their financing needs.