Exploring Bridge Loans For Early-Stage Startups – Weighing Your Options

Bridge loans for early-stage startups are an excellent strategy to cover your short-term expenses. These loans support the company by providing the resources needed to sustain growth between funding rounds. You can use this money as short-term working capital to purchase inventory or tools.

A typical bridge financing round is executed within a few days, ensuring much-needed liquidity for smooth cash flows. It enables the company to continue operating until it is stable enough for the next funding round. You could delay running a funding round until the company achieves a higher valuation.

As a result, you can negotiate for more favorable terms and conditions and, perhaps, lower interest rates. You can also source bridge loans with flexible payment terms, though you might have to pay higher interest rates. Also, expect to offer some form of collateral to your lenders.

Using bridge loans for early-stage startups strategically is crucial, and before diving into this option, you’ll weigh your options carefully. Be sure to understand the upsides and downsides of bridge financing and the potential advantages alternative sources can offer you.

Sourcing Bridge Loans for Early-Stage Startups – Estimating Costs and Payments

Before getting bridge financing, the first step is to analyze the company’s financials and ascertain the amount needed. You’ll also estimate cash flows and revenues to work out payments along with the collateral you can offer. Next, you’ll scout the market for lenders offering you short-term loans.

As with all other funding options, bridge loans for early-stage startups come with overhead costs. Here’s what you need to know.

• Expect to carry expenses like origination fees and legal fees, which are payable regardless of whether your loan application is accepted.
• Estimate the charges payable to lawyers to draw up the contracts and necessary paperwork.
• You’ll cover appraisal charges, closing costs, and notary fees.
• Ongoing and upfront fees to get money in the bank are also payable.
• Hiring a broker to connect you with the right lenders and negotiate favorable terms is a good option. But their services come at a cost, so prepare for that expense.

You’ll incur the above costs in addition to the high interest rates. On the upside, the monthly payment structure is typically affordable since you’ll only cover the interest. Make sure to account for all these factors when comparing the loan products different lenders offer.

Regardless of how carefully you structure the loan and payments, it’s advisable to prepare for the possibility of not being able to repay the loan. Macroeconomic conditions and unexpected market downturns could make it challenging to keep up with payments. Having a plan B in place is preferable.

Research your refinancing options in case you can’t make the exit deadline. Work out how to refinance the loan and the rollover facilities lenders will provide. Being prepared for all possible scenarios ensures you don’t face unexpected situations.

Structuring Bridge Finance Products

Bridge finance is essentially a form of debt financing, and you could reach out to existing investors for backing. These entities are more likely to understand the challenges the company is facing and its potential efforts for rapid development.

You can structure the loan as convertible debt with a valuation cap. Alternatively, offer to convert the stock at a discounted rate in the next priced equity funding round. You’ll create a clear and detailed roadmap outlining the milestones the company hopes to achieve with the capital.

This strategy will give you a negotiating advantage for favorable terms and conditions. At the same time, ensure complete transparency and understand the rights investors expect in exchange for the funding. For instance, conversion rights that can result in dilution or decision-making rights.

Sign the term sheet only after discussing it with your legal team and funding advisor. The term sheet will include information such as:

• The loan is debt-based or equity-based. You’ll repay debt loans with interest and overhead fees and charges. However, equity-based loans convert into equity stock under pre-determined conditions.
• The loan amount needed to fill the gap until the subsequent funding round or a milestone, such as a valuation amount.
• Use of funds or the specific purpose for which you’ll use the money. For instance, research and development, hiring new talent, operational expenses, or an acquisition that will generate revenues.
• Repayment terms and mode of payment, such as in full or in stock.
• Contractual provisions unique to the company, investors, and type of loan.
• Exit plan or deadline for repaying or converting the loan.

Benefits of Bridge Loans

Bridge financing for early-stage startups has several advantages. Here’s a quick look at them:

• The most significant advantage of bridge financing is the quick turnaround, which makes it ideal when you need funding quickly. You can execute the process within a few days instead of months, like venture capital or private equity.
• Since bridge loans are short-term, you can use the money without worrying about locking in the financing option. You can pay off loan products that are not a right fit for the company in the long run.
• Expect to pay a lower interest rate as compared to long-term loans.
• Lenders offering bridge loans are an entirely distinct pool of investors from typical venture capitalists, banks, and private financial institutions. Approaching them gives you access to a new funding source during economic cycles when VC market sentiment is ebbing.
• Bridge loan providers are usually open to funding companies with low credit scores. Since they offer loans in exchange for collateral, the probability of getting approval is higher. Further, they’ll accept those assets as collateral that traditional lenders may not want to consider.

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Downsides of Bridge Loans

Despite the multiple advantages, bridge financing has its share of downsides. Here’s what you need to know:

• These loan products come with a fixed payment deadline and locked-in loan terms. You’ll have to make payments on schedule.
• Such loans are only suitable for short terms usually to cover shortfalls in working capital. You can only align them to meet immediate company goals.
• Bridge financing can be expensive, with multiple overhead costs and expenses. You’ll carefully calculate the net amount available for company use before accepting the loan. Be sure to look for hidden expenses that can raise the costs of getting financing.
• Investors may request conversion rights or warrants in exchange for the loan. This means the loan will convert into equity shares by a specific date or during the next funding round. Factor in the risk of dilution before accepting.
• Future VCs and financial institutions may not favorably view a company taking bridge loans. They might see the loan as a negative indication that the company is struggling without adequate working capital. Investors may see it as a sign of poor performance or inefficient financial management, which could impact further funding rounds.
• You cannot substitute this form of debt financing for long-term equity capital, nor is it a viable business model.

A crucial factor to remember when considering bridge loans for early-stage startups is to lower the company’s valuation strategically. Future investors will be wary of funding subsequent rounds and may want better terms and conditions. You also run the risk of a down round and its disadvantages.

Create a balance between low to high-interest bridge loans and giving up ownership rights with low to high company valuation. The key here is to use robust financial projections to present the company’s growth patterns under robust leadership.

Mitigate the Downsides of Getting Bridge Loans – Approach Existing Investors

Ensuring transparency and open lines of communication with investors is the best strategy to adopt when mitigating the risks. As explained in the foregoing sections, approaching existing investors for bridge loans for early-stage startups is always advisable.

Investors who have provided funding in the earlier stages have noted the company’s potential and assessed its viability. When you discuss objectives like extending the runway until the next funding round, it will make complete sense to them.

VCs and PE firms familiar with the industry and its challenges understand how the capital infusion can stabilize the company. They may be interested in funding product development, R&D efforts, hiring new talent, or purchasing inventory to meet a demand surge.

Most importantly, sophisticated investors will recognize that bridge loans do not necessarily indicate poor performance. But instead, it suggests a growth spurt that cannot wait for the next funding round. They also realize that cash inflows from long-term and bulk customers can be unpredictable.

A quick injection of cash to bridge short hurdles can ensure long-term sustainability and scalability for the company. Current investors who have done their due diligence and funded the company are vested in seeing it succeed. That’s the message you need to send across.

The existing relationship can also streamline structuring and speed up the financing process, making it a win-win for both parties.

At the same time, understand that your investors could negotiate for higher returns. They may want more than 20% to 25% returns for 12 to 18 months of convertible notes. You may have to offer more than 40% returns during the conversion. So, weigh your options carefully.

The startup and early-stage company funding ecosystem has different classes of investors you can approach. Check out this video in which I have explained the types of investors. Understand who they are and the kind of capital they offer before reaching out.

How About Revenue-Based Financing as an Alternative?

Revenue-based financing can be an alternative to bridge loans for early-stage startups. In this form of debt financing, you’ll commit a percentage of the company’s future revenues as payment for loans. Alternatively, you’ll commit to paying a fraction of the interest and principal per month.

The premise here is that payments will be made from the company’s regular revenues. Such loans are best suited for verticals like subscription-based, SaaS companies, eCommerce, and service-driven businesses. However, typical loan amounts are less than other debt financing options.

At the same time, you’ll take advantage of quick financing and zero-interest accumulation. Nor will you risk dilution because of SAFEs and convertible notes. But, if your company cannot expect consistent revenues per month, this option may not be advisable.

How About Venture Debt as an Alternative?

Venture debt is another option you can consider for your short-term funding needs. Entities in the venture capital ecosystem typically provide such loans since they have a higher risk propensity than banks. You can also expect higher flexibility when structuring the loans and more favorable terms.

Venture debt investors consider bridge loans as a starting point to back the company in anticipation of funding future rounds. Their objective is to continue supporting the company because of its immense potential and viability.

Entities offering venture debt are sophisticated investors who understand capital markets and are likely familiar with the vertical. Their industry-specific expertise and substantial capital reserves make them excellent partners who’ll see the company through its evolution and growth.

Most importantly, they understand the inherent risks of backing your company, which is why they may offer you better terms. At the same time, understand that they will expect compensation for the risks. Expect them to negotiate high interest rates and collateral they can sell to recover their money.

Venture debt providers may also require warrants that they can use to purchase a portion of your stock. This clause comes with the risk of dilution if they demand to buy shares at pre-determined prices. Also, factor in the legal costs for structuring and closing the loan.

If bridge loans for early-stage startups don’t align with your business goals, you can also consider getting lines of credit. Working capital advances are also an option to consider.

The Takeaway!

Consider bridge financing to extend and sustain the company’s runway until the next funding round. You should also research the market for other options better aligned with the company’s goals. Savvy entrepreneurs can explore options like revenue-based financing, venture debt, and lines of credit.

Understand the pros and cons of each option with regard to repayment terms, dilution risks, and interest rates. Don’t overlook the costs of financing that you’ll incur over and above the interest payable to the investors.

Remember to structure the loan strategically so you can keep the company operational with, perhaps, a higher valuation by the time it’s time for the next funding round.

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