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.).
- Bridge financing is short-term financing aimed to provide funds to companies until they obtain long-term financing.
- Bridge loans are expensive, given the risks associated with such types of loans.
- Equity bridge financing represents an exchange of capital from the lender’s side for an equity stake in a company from the borrower’s side.
How Does Bridge Financing Work?
There are many ways an enterprise can secure bridge financing, and the options will depend on the borrower’s credit profile and history. More options are available to a company with a solid credit history and market position and one that needs a little short-term credit than a company in huge financial distress.
It is extremely important that companies consider bridge financing very carefully because it can entail such a high interest rate that can lead to even more financial problems.
Bridge financing is not straightforward and often includes a lot of provisions that help to protect the lender.
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.
Bridge Financing and IPOs
Bridge financing is used before a company goes public, offering its shares on a stock exchange to investors. Such a type of financing is originated to account for IPO expenses the company needs to incur, such as underwriting fees and payment to the stock exchange. Once the company’s raised money during the IPO, it will immediately pay off the loan.
The bridge funds are typically provided by an investment bank that will underwrite the new stock issue. The company will initiate a number of shares to the bank at a discount on the original price offered to the investors during the IPO. It is a so-called “offsetting effect.”
It is common for venture capital firms to charge a 20% interest rate to provide financing due to the amount of risk taken. They often require a full payback in one year. The interest rate may increase if the borrower does not repay the loan on time, for example, to 25% p.a.
Venture capital firms may use a convertibility clause, meaning an option to convert a certain credit amount into equity at a specified price. For example, $5,000,000 out of $10,000,000 can be converted into equity at $5.50 price per share if the venture firm decides to do so. The price per share may be further negotiated and can be a fair price of the company’s share.
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