What is Bridge Financing?
Bridge financing is a form of temporary financing intended to cover a company’s short-term costs until the moment when regular long-term financing is secured. Thus, it is named as bridge financing since it is like a bridge that connects a company to debt capital through short-term borrowings.
An institution that urgently needs capital to meet its short-term obligations (e.g., working capital financing) can choose to obtain a bridge loan that serves as a form of bridge financing. It is usually issued by an investment bank or venture capital firm.
Equity financing (equity-for-capital swap) can also be an option for those seeking bridge financing. In all cases, bridge loans are expensive because lenders bear a significant portion of default risk loaning the funds for a short period.
Bridge financing is used in the initial public offerings (IPOs) to cover the flotation expenses (e.g., underwriting, stock exchange fees, etc.).
How Bridge Financing Works
Bridge financing “bridges” the gap between the time when a company’s money is set to run out and when it can expect to receive an infusion of funds later on. This type of financing is most normally used to fulfill a company’s short-term working capital needs.
There are multiple ways that bridge financing can be arranged. Which option a firm or entity uses will depend on the options available to them. A company in a relatively solid position that needs a bit of short-term help may have more options than a company facing greater distress. Bridge financing options include debt, equity, and IPO bridge financing.
Types of Bridge Financing
Debt Bridge Financing
One option with bridge financing is for a company to take out a short-term, high-interest loan, known as a bridge loan. Companies who seek bridge financing through a bridge loan need to be careful, however, because the interest rates are sometimes so high that it can cause further financial struggles.
If, for example, a company is already approved for a $500,000 bank loan, but the loan is broken into tranches, with the first tranche set to come in six months, the company may seek a bridge loan. It can apply for a six-month short-term loan that gives it just enough money to survive until the first tranche hits the company’s bank account.
Equity Bridge Financing
Sometimes companies do not want to incur debt with high interest. If this is the case, they can seek out venture capital firms to provide a bridge financing round and thus provide the company with capital until it can raise a larger round of equity financing (if desired).
In this scenario, the company may choose to offer the venture capital firm equity ownership in exchange for several months to a year’s worth of financing. The venture capital firm will take such a deal if they believe the company will ultimately become profitable, which will see its stake in the company increase in value.
IPO Bridge Financing
Bridge financing, in investment banking terms, is a method of financing used by companies before their IPO. This type of bridge financing is designed to cover expenses associated with the IPO and is typically short term in nature. Once the IPO is complete, the cash raised from the offering immediately pays off the loan liability.
These funds are usually supplied by the investment bank underwriting the new issue. As payment, the company acquiring the bridge financing will give a number of shares to the underwriters at a discount on the issue price which offsets the loan. This financing is, in essence, a forwarded payment for the future sale of the new issue.
When Does a Company Need Bridge Financing?
Let’s look at an example when an enterprise can be compelled to go for a bridge loan.
Imagine ABC Co. being approved for a $1,000,000 loan in a bank, but the loan is tranched, meaning it consists of three parts (three installments). The first tranche will be settled in six months.
The company needs funds at the moment to operate and thus will be looking for a cover to account for said six months. It can apply for a six-month bridge loan that will provide enough money to survive until the first credit tranche flows to the company’s bank account.
What is Equity Bridge Financing?
Bridge loans imply a very high interest rate, and it is not acceptable for every company. Instead, companies are ready to exchange capital for an equity portion of the company. In such a case, venture capital firms will be approached instead of banks and offered equity ownership.
Venture capital firms will go for a deal in case they assume the company will succeed and become profitable. If the company becomes profitable, it means that the value goes up, and thus the venture cap’s stake increases in value.
Advantages of Bridge Financing
- These loans are processed very quickly and instantly.
- They can help improve those with a bad credit profile if the entity serves timely loan payments throughout the loan tenure.
- It helps in quick finance pursuing auctions and immediate business needs.
- The terms and conditions of bridge loans depend on the lenders’ flexibility.
- It enables the borrower to manage its payment cycles.
Disadvantages of Bridge Financing
- The bridge loans carry a high-interest rate and are very expensive.
- Since the loans are very expensive, they pose a high default risk from the borrowers’ end.
- The lenders charge high fees on the late payments.
- The balance keeps compounding with the finance rate for each unpaid loan.
- The borrower may be unable to exit such loans as he may fail to get loans from traditional lenders.
- The borrower with a bad credit profile may not access bridge loans.
- The lender may ask for collateral before providing bridge loans to insure borrowers with bad credit profiles.
- The lender may additionally charge high fees on originations and foreclosures.
- These are short-term loans with a time frame of 3 weeks to 12 months.
- The loans are repaid once finance is arranged from the existing arrangement.
- Since the cost of lending is high for such loans, these loans are refinanced from the traditional lender.
- These loans are not regulated under any main regulatory body.
- Such loans are non-standard. There are no concrete covenant arrangements between the lender and borrower.
Example of Bridge Financing
Bridge financing is quite common in many industries since there are always struggling companies. The mining sector is filled with small players who often use bridge financing in order to develop a mine or to cover costs until they can issue more shares—a common way of raising funds in the sector.
Bridge financing is rarely straightforward, and will often include a number of provisions that help protect the entity providing the financing.
A mining company may secure $12 million in funding in order to develop a new mine which is expected to produce more profit than the loan amount. A venture capital firm may provide the funding, but because of the risks the venture capital firm charges 20% per year and requires that the funds be paid back in one year.
The term sheet of the loan may also include other provisions. These may include an increase in the interest rate if the loan is not repaid on time. It may increase to 25%, for example.
The venture capital firm may also implement a convertibility clause. This means that they can convert a certain amount of the loan into equity, at an agreed-upon stock price, if the venture capital firm decides to do so.
For example, $4 million of the $12-million loan may be converted into equity at $5 per share at the discretion of the venture capital firm. The $5 price tag may be negotiated or it may simply be the price of the company’s shares at the time the deal is struck.
Other terms may include mandatory and immediate repayment if the company gets additional funding that exceeds the outstanding balance of the loan.