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.
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.
Why Do Startups Need Bridge Rounds?
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.
To Achieve Milestones and Targets
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.
To Go Public
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:
Get into mergers and acquisitions
Implement price reductions to drive out competitors
Get financing toward an initial public offering
Changing Market Conditions
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.
How Do You Structure A Bridge Round?
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.
How are Bridge Rounds Different From Seed Funding and Series Rounds?
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.
Why Should You Consider Using Bridge Financing?
Bridge financing has some benefits for both startups and investors.
Benefits to Startups
Financial cushion: Bridge rounds offer startups a cushion during challenging times. If the company is struggling financially, a bridge loan keeps the company running and prolongs the life of the business until the next round of funding. The startup can turn things around before the Series A funding round.
Increased company valuation: If the startup is performing well and expanding, a bridge loan provides funds to boost the growth and allow existing investors to profit. Additionally, entrepreneurs can use this to negotiate a better deal with future investors.
Ease of use: It is much easier for startups to receive a bridge loan than to work out the value of their business. Fortunately, bridge rounds take less time to close than Series A rounds. Therefore, if the startup does not have enough time, they can apply for this as they wait for bigger funding rounds.
More time for product development: Bridge rounds give the company more time to prepare and test its products. The startups can use this time to reach important milestones.
Benefits to Investors
More Options: With bridge loans, investors can end their engagement with a startup as soon as they get their money back or continue to invest in subsequent rounds.
Small Investments: A bridge loan is a fairly small investment for bridge round investors. However, if it’s converted into equity, it could be a big payoff. Bridge rounds also offer an opportunity to negotiate favorable terms. Investors have the leverage to ask for better terms, such as a lower valuation cap on the convertible note.
Reasons to Consider Not Using Bridge Financing
Bridge financing also comes with several risks for both startup founders and financiers. Here are the downsides.
Risks for Founders
The money could be insufficient: Whether you are getting new investors or using the current ones, you need to decide how much bridge funding the company needs. If you get the number wrong, you could give away too much of the company or not receive enough money to get you to the next round.
Not ideal if you are desperate: If the company is in dire need of money, the company founder or directors could make bad decisions with regards to receiving bridge financing loans.
Red flag for other investors: A bridge loan sometimes signifies the startup is struggling financially. This might even put off future investors. Because of this association with distressed companies, founders might face challenges explaining why they need money.
Lower bridge round valuations could put off future investors: Although it’s common to offer lower valuations to bridge round investors, it might deter future investors if they can’t get the same terms.
Founders have to make certain sacrifices: If the company is struggling, the founders might need to make sacrifices like forgoing salaries to close the bridge round.
Risks for Investors
Loss of investment: One of the biggest downsides of bridge financing is that the investor might lose all their money. If the startup needs the additional money to remain afloat after the seed funding, there’s a high chance it might fail. As an investor, you’ll lose the original investment and incremental capital.
The next round might not happen: Bridge rounds sustain the company until the next round. However, if the next round of funding does not happen, the investors might lose their entire investment.
Decision on the investment amount: Just like startup founders, investors have to decide on how much money to invest. They have to give enough cash to keep the company from going bankrupt, as well as avoid investing too much just in case the startup fails.
Should You Invest in a Bridge Round?
As an investor, you should consider the following when approached by a startup for a bridge loan.
Whether the founders provide regular updates such as the revenue, monthly burn rate, and when the cash problems are expected to end.
Whether other investors have agreed to join in on the bridge round.
The probability that the company will succeed if the bridge round goes through.
Whether there’s a lot of pressure from the founder. This could indicate the company is in distress.
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.
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