What is bridge financing?
Bridge financing, generally speaking, is interim financing that companies and other stakeholders provide in trying to shore up their short-term situation to create enough bridging time until a long-term financing opportunity can be arranged. Venture capital firms and investment banks often offer bridge loans or equity.
Bridge financing is also used in IPO, and in this case, the process of exchange could be ‘equity for capital’ instead of a loan.
Key takeaways
- Hence, it is another type of short-term finance and aids in the consolidation of the short-term position till long-term finance can be arranged.
- Other alternatives for bridge financing include debt or equity financing.
- It is of short duration and carries interest rates.
- Equities need to be compromised in favor of finance in equity bridge financing.
- The IPO bridge financing is used by companies that go public. The financing is paid at the time of IPO and then repaid once the company becomes publicly held.
How Bridge Financing Works
Bridge financing “bridges” the gap when a company’s money is running out and waits for the infusion of funds some time down the road. It is a type of funding that most businesses frequently use to support their immediate working capital needs.
Various structures can be applied to bridging finance. Which one an entity or firm settles on shall depend on the options available to them. A firm with a relatively healthier position and one requiring only a little short-term help shall more likely have options than one dealing with higher distress. Options of bridge financing include debt, equity, as well as IPO bridge financing.
Types of Bridge Financing
Debt bridge financing
Another available alternative to bridging finance is called a bridge loan. This kind of finance is short-term, high-interest financing, which can also be referred to as a bridge loan. Companies that avail themselves of bridge financing by using a bridge loan must exercise caution because the interest rate may be so exorbitant that it aggravates further financial distress.
For instance, a business may be able to meet the criteria for a $500,000 loan through a bank but the loan is a tranches-based loan and six months in advance when the first tranche will arrive. That company, therefore, must need a bridge loan. The company can, therefore, apply for a short-term six-month loan that will only just be enough to keep the company alive until the first tranche arrives in the company’s bank account.
Equity Bridge Loan
Sometimes, firms just do not wish to assume debt, which bears relatively high rates of interest. For this reason, venture capital firms can bridge finance a round and therefore provide the company with capital until it can raise a larger round of equity financing if desired.
In this way, the company can accept to give equity ownership of the venture capital firm in place of financing which would take several months to a year. The venture capital firm will accept such an offer if it believes that the company will eventually become profitable since its equity ownership in the company will be appreciated.
IPO bridge financing
Investment banking parlance describes bridge financing as the source of funding by which the company funds itself before its IPO. The nature of bridge financing is to fund expenses related to the IPO and is, in any case, essentially short-term in duration. The loan obligation is immediately settled with the offering proceeds upon completion of the initial public offering (IPO).
The finance for this bridging is often provided by the investment bank which underwrites the new issue. The company undertaking the bridge finance will sell some number of shares at a discount on the issue price to the underwriters serves as evidence of the loan. Essentially, this financing is pre-payment for the eventual sale of the new issue.
Example of Bridge Financing
- Bridge finance is a short-term solution.
- It can involve debt or equity financing.
- Often used before IPOs to cover expenses.
Bridge financing is pretty widespread as in nearly any area, some firms do poorly. It may even be more common in businesses that require a lot of capital. For instance, the mining industry is full of small players who frequently rely on bridge financing to get a mine open or to cover operating costs until they can float more shares very common mechanism of raising capital in the industry.
Bridge financing is usually transparent and has a lot of terms that are meant to safeguard the person making the loan.
For instance, a mining company might borrow $12 million to raise the capital required to exploit a new mine that would fetch more profits than the loan repayable. A venture capital firm might advance the money but because of the risk taken, demands a 20 % rate per year and that the fund be paid back within one year.
The most expensive method by which a firm raises capital and hence not the best source to raise money is bridge financing.
There may be other terms provided for in the loan term sheet. For instance, an increase in the interest rate might be preferred if the loan has been outstanding for quite a considerable period. It may go to 25% for example.
A convertibility clause may be used by the venture capital company. That means it can, if it desires to do so, make part of the loan into equity by paying an agreed-upon stock price. For example, the venture capital firm may, when it wishes, convert the $4 million of the $12 million loan into equity at $5 per share. The $5 may have been negotiated or again just the market price for the company’s shares at the time of the deal. Some terms may even require repaying compulsorily with immediate effect if the company increases more funding that exceeds the remaining balance on the loan.
Pros and Cons of Bridge Financing
Pros
- Bridge financing provides a short-term cash infusion.
- It helps cover expenses to keep a business running.
- Useful for getting important investments or projects started.
- It can be a viable option when other financing options are unavailable.
- The potential payoff may outweigh the higher costs involved.
Cons
- The biggest risk of bridge financing is falling deeper into debt.
- Bridge loans usually have high interest rates and require quick repayment.
- Equity bridge financing often comes at a premium cost.
- It might mean giving up stock at a steep discount.
Conclusion
Short-term arrangements are typically highly cost-expensive and often even impose themselves under their own financial burden to recover costs such as short-term working capital requirements and expenses incurred to go for an IPO.
Bridge financing is the provision of interim short-term capital to enable an entity to cope until the time when cash infusion takes place or proper, long-term financing is available.
These include the issuance of debt whereby the company receives cash instead of a loan, and equity, in which he receives shares of ownership from a company.
FAQs
What is bridge financing?
Short-term loans of this kind, known as “bridge financing,” are used to cover expenses while longer-term funding or sources of income are secured.
Is it Possible to Repay a Bridge Loan Early?
As a rule, most bridge loans don’t carry any prepayment penalties, but it does not harm to ask as an additional precaution. The flexibility of being able to pay ahead in return is a great advantage, especially in circumstances whereby another source of funding cheaper and readily available comes along, so the loan can be paid off in full, saving the borrower on interest charges.
Is obtaining a bridge loan a wise decision?
Bridge loans have high interest rates, short repayment terms, and other disadvantages, even though they can be a smart strategy to handle business or investment transactions or to purchase a home while selling your current property.
Why do bridge loans cost so much?
Bridge loans have higher interest rates because they are only meant to be used for very short periods. Since their main focus is on offering longer-term products like 15-year and 30-year mortgages, the majority of conventional lenders do not offer bridge loans with short terms.
