Bridge Loans/Investments as Interim Funding (Silicon Valley x LexStart)
Silicon Valley: S01E03 (Part 1) - Peter Gregory offers to make a “bridge loan” to one of his investee companies.
A bridge loan is a gap financing arrangement that helps bridge the gap between two transactions, typically a short-term fund requirement and a long-term loan. It provides the borrower with immediate cash flow. This type of loan is typically taken out for a period of 2 weeks to 3 years, depending on further financing arrangements.
Extensively employed in the real estate sector, homeowners often take out bridge loans toward the purchase of a new home while they wait for their current home to sell.
In India, what is most prevalent is the concept of a “bridge investment” or “bridge funding", or “bridge round” as they are most commonly referred to.
A bridge round takes place when the startup is in the process of raising the next round of funding, say a Series A or a Series B, but the process is taking longer than expected and the startup needs a lifeline or some liquidity in the meantime to meet financial obligations in the interim period.
We are seeing a number of bridge rounds happen during this period of Covid-19; the primary being that the investors may not be as optimistic with the pre-Covid valuations, and the startups, while still needing the funding, do not want to compromise on valuations. As a result, most fundraising rounds at this stage are without arriving at a valuation, with the valuation dependent on the subsequent round of funding.
The key features/terms of a bridge round:
While mostly led by existing investors in the company, an external investor may also participate in a bridge round of funding.
No valuation is assigned in this round and the valuation is dependant on the subsequent round of institutional funding or certain milestones. For example, the company achieving a certain EBIDTA in two years or the company amassing a certain user base, etc.
The instrument used for this purpose is generally a compulsorily convertible preference share (CCPS). However, in some high-risk startups, and especially if external investors are participating, they may consider a compulsorily convertible debenture (CCD).
Key issues promoters should watch out for:
When doing a bridge round, it is paramount to focus on the valuation terms. These terms should not be subjective. Therefore, clearly define what the next round of institutional funding should be, how the discount rate will be calculated. If you have incorporated milestone-based parameters, ensure they are set out objectively. As a founder, you also need to look out for dilution of your shareholding, therefore, do not forget a valuation floor!
Key issues investors should watch out for:
The above mentioned considerations for founders also apply to investors. It is critical to have objective parameters to avoid disputes in the future. Even setting out illustrations with varied hypothetical scenarios helps take away some ambiguity. While from a founder’s perspective it is important to have a valuation floor, from an investor’s perspective, it is important to assign a cap to the valuation.