How Bridge Loans Work

Such financing can be a short-term lifeline in stormy times. But since the terms can be harsh, regard such loans as a last resort

By Tom Taulli

I recently received an e-mail from an early-stage software company that has landed $1 million in funding from angel investors (BusinessWeek.com, 10/10/08) over the past few years. However, as with many other small companies I've heard from these days, its financial situation is grim. Simply put, the company said it was two months away from running out of cash. A venture capitalist, however, was considering investing $2 million within the next couple months.

What to do in this situation? The software company could try to structure a so-called bridge loan. Normally only in the range of $100,000 to $250,000, such a loan is a short-term note that has a maturity of 30 days to nine months and an interest rate that may range from 7% to 12%, normally payable at the end of the term on the loan. The loan would provide gap financing until the arrival of a new round of funding, a payment from a large customer, or even the purchase of the company.

Since bridge loans require speed and often come about in tough times, the borrower has minimal leverage. As a result, the terms can be particularly harsh. Some examples include:

• Warrant coverage. This is a percentage of the amount invested that an investor can purchase in the company's stock. Thus, if you are raising $100,000 and there is 100% warrant coverage, then the investor can purchase up to $100,000 of the company's stock. The percentage is negotiable. But expect warrant coverage of 50% to 100%. In some cases, the percentage can be 200%.

• Security. You may have to pledge some or all of the company's assets for the loan. The assets can include receivables, fixed assets, and intellectual property. The founders may even have to pledge their personal assets, such as real estate. In other words, if a company cannot pay back the loan, the founders may lose their business and personal assets.

• Origination fee. An investor might charge 1% to 2% of the loan amount as compensation for structuring the deal.

• Restrictions. An investor may require that the company reduce its expenses and not make any large investments.

Perhaps the biggest challenge for a bridge loan is finding investors. In the case of the struggling software company I mention above, it might try to persuade its VC to extend a bridge loan. In a way, it is a good strategy to discover if the VC is truly interested in investing in the company. Other options include angel networks and any other wealthy people within its network. Obviously, sources that already understand the business won't require it to go through as much due diligence as new investors.

Yet even if you approach investors who understand your company, the process can still be time-consuming, lasting a month or so. In the meantime, it is common for investors to get spooked—especially in today's volatile markets. When the Dow falls 5% to 10% on a recurring basis, it's natural for investors to refrain from any commitments.

The dot-com blowup of 2000-01 provides some insight into the likelihood of landing a bridge loan now. During this brutal period, angel investors and VCs closed their checkbooks. In the vacuum, some gutsy bridge funders—usually wealthy individuals—put together onerous deals. Sadly, it was not uncommon for the company founders to lose their equity.

My advice for strapped companies about whether or not to pursue a bridge loan? While every situation is different, I would consider it a last resort unless your company has a strong customer base and needs a temporary injection of capital. Otherwise, I would look at moving your company to hibernation mode and avoiding the harsh costs of such a loan.

Tom Taulli is a noted finance author and blogger.