Startups seek different types of funding from investors. For some entrepreneurs, the initial seed capital is enough to sustain the operations until the next funding round. However, some startup founders require additional money between financing rounds; therefore, they have to raise bridge funding.
This guide will look at bridge financing, how it works, why startups need to use bridge rounds, and the pros and cons to help you decide whether bridge rounds are a good option for you.
To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.
A bridge round, also known as bridge financing, is a short-term, interim financing round that startups need to stay afloat until the subsequent larger financing round. For instance, a startup founder can get a bridge round between seed and Serie A funding.
Investors offer startup businesses such short-term loans on the basis that they will get their money back. Although most people think bridge rounds imply the business is in financial trouble, this is not always the case. A bridge round can provide interim capital to help with growth or to prepare the company for an IPO.
A bridge round is more efficient, easier, and less time-consuming when the startup needs short-term funds. They come in handy when the business lacks the financial ability to survive without funds for an extended period.
Every startup needs a bridge round for additional cash. However, businesses need cash for different reasons. Here are some of them.
One of the main reasons why most startups fail is a lack of cash. When the company is not doing well due to a sudden change in market conditions and running out of cash, it needs a bridge round to sustain it. Bridge financing will raise money and provide enough resources for the company to remain functional for a long time. Bridge rounds help entrepreneurs to gain enough funds for day-to-day expenses.
Startups raise bridge funding to hit certain milestones to enable them to receive more funding from their investors. Once the business achieves these milestones, the valuation will go up for the next priced round. Additionally, the startup could be experiencing exponential growth; therefore, the additional cash helps sustain the pace.
Large companies also use bridge rounds to get additional capital to prepare for an IPO. If this is the case, it becomes easier to get funding from investors. A startup might also be planning to go public with its services and products. Receiving a bridge round will allow the business to:
Startups look for a bridge round due to changing market conditions, such as a new competitor or the market is growing much faster. Founders need to be honest with potential investors about why they need to raise a bridge to increase the chances of receiving the funding.
A bridge round is typically structured as convertible debt. With this form of financing, initial investors receive a promissory note documenting the bridge investment in which the startup promises to repay the lenders, sometimes with interest. However, instead of getting paid back in money, investors receive the equivalent of that money converted to equity stock instead of getting paid back in money.
Additionally, investors won’t know the company’s value until the next price round. Like other forms of venture investing, bridge rounds are negotiable. If the startup faces financial problems, investors can negotiate a lower valuation than the previous funding round.
If the existing investors are not participating in your bridge round, you need to provide some metrics to show the momentum of the business and convince them. Some metrics to consider include revenue, sales velocity, completed trials, and the close ratio.
If the parties choose to use convertible debt for the bridge round, they can include a discount rate, valuation cap, or warrant.
Investing in a bridge round is high risk; therefore, you’ll have to provide enough evidence to put your prospective investors at ease. One way to do this is by including a discount in the bridge financing deal. Typically, founders offer a 20% discount on future financing loans.
Valuation caps protect investors from unrecognized gains in business value during a bridge financing period that would reduce their ownership. For instance, a $100,000 bridge loan guarantees the investor 20% of the business if the founder placed a $500,000 valuation cap.
Warrants in bridge financing give the investor the right to buy shares at a set price in future financing rounds. For example, a $100,000 bridge loan with a 20% warrant coverage enables the investor to purchase $20,000 worth of stock in the future.
A bridge round differs from a seed round, Series A, and the subsequent funding because of the investors, amount raised, and purpose. While seed funding is meant to get the company off the ground, bridge rounds are required to keep the company afloat.
In addition, the investors that participate in Series A funding are usually new, while the bridge financiers are, in most cases, existing investors with financial interests in the startup. Bridge rounds also tend to be smaller. For example, a seed round can be $2 million, a Series A round is typically between $4 to $10 million, while a bridge round may be about $0.5 to $1 million.
Bridge financing has some benefits for both startups and investors.
Bridge financing also comes with several risks for both startup founders and financiers. Here are the downsides.
As an investor, you should consider the following when approached by a startup for a bridge loan.
A bridge round can determine whether a startup fails or grows. Before seeking this form of financing, ensure that you have enough reasons and metrics to convince investors to put capital into your business.
You may also be interested in learning about cap tables.
To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.
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