The Truth About Bridge Loans

“We’ll likely need a bridge.” That’s one of the most dreaded phrases we can hear from the CEOs of companies we invest in.

Bridge financing, put simply, is an IOU backed by the promise of raising more money in the future. When it happens, you’ll inevitably witness some VC gallows humor, as one obnoxious person in the room asks, “Is this a bridge or a plank?” It never fails.

The truth is that bridge notes are used all the time. Perhaps the next round of money from new investors didn’t arrive as quickly as projected. Maybe sales are down. The list goes on and on as to possible reasons behind the request.

For companies that are crushing it, bridge financing can be employed to extend a runway past a significant valuation point so that existing investors can capture that new value for themselves. But more often than not, bridge notes are used to extend the life of a struggling startup whose future is unknown. In either case, savvy entrepreneurs should know what they are and how they work.

Most bridge notes take the form of convertible debt. That is, VCs expect to be paid back not with dollars, but with conversion to company stock upon maturity. Well-understood loan elements like principal and interest apply to this conversion, but bridge notes also include other “equity kickers” like valuation caps, discounts and warrants.

Valuation caps protect investors from unrecognized gains in company value during the bridging period that would otherwise shrink their ownership. For example, a $1 million bridge loan with a $5 million cap would guarantee the lender at least 20 percent of the company prior to the additional financing.

A discount is just that—a discounted price on shares in the future round of financing. If the aforementioned transaction were accompanied by a 20 percent discount, the lender would be entitled to $1.25 million in shares in the future financing round for the bargain price of the $1 million loan.

Like an option, a warrant is the right to purchase shares at a set price in the future. Back to our sample transaction: A $1 million bridge loan with 20 percent warrant coverage would entitle the lender to buy $200,000 worth of stock at the next round’s prices well into the future. The lender may never exercise this right, but it could become massively beneficial if the company experiences skyrocketing growth.

It would be easy to say that bridge loans are only risky investments made defensively against the threat of failure, but that simply isn’t true anymore. In fact, they’ve become a fairly standard financing move, even used as the first infusion of capital raised by a startup. The appeal? It’s much easier for entrepreneurs to negotiate the terms of a bridge note than to determine the value of their startup and how much an investor’s equity stake will be. That’s good news, since a bridge could help business owners cross over to sustainability when there may not be another deal in sight.