Bridge financing is a short-term financial instrument aimed at addressing a company's immediate liquidity needs, effectively helping to "bridge" the gap until its financial situation stabilizes. Typically, bridge financing is utilized to cover ongoing expenses, such as salaries and other recurring monthly costs.
Bridge Financing for Secured Funding (Project Bridge Financing)
Nearly all growth companies face a common challenge when utilizing public funding: financing is disbursed against incurred expenses. As funding is provided retroactively, it is essential to secure financing to cover project costs during its execution.
It is quite common for early-stage growth companies to seek bridge financing with Variable Payment Obligation (VPO) terms for for example EU-funded projects, either from financial institutions or private investors. Typically, lenders require that the grant for the bridged project be deposited into a separate escrow account. Additionally, it is often expected that the management will provide partial personal guarantees for the financing.
Once the company receives an approved financing decision for the project and utilizes bridge financing to complete it, the financing becomes relatively low-risk for the involved parties. However, it is important to note that this arrangement is not entirely risk-free, as the company must also manage financing for other operations beyond the specific project.
Series A Bridge Financing
When a startup is in the seed phase and operating with relatively limited funding, it is crucial to evaluate its readiness for a Series A funding round in the context of its overall liquidity and runway situation. Startups that experience negative cash flow and find cost reductions to be unrealistic often explore bridge financing solutions for the A round. A distinctive aspect of bridge financing in these scenarios is the uncertainty surrounding the successful realization of the anticipated funding (A round).
In recent times of zero-interest environment, coupled with banks' willingness to provide financing backed by Finnvera guarantees, has positioned VPO financing as a viable bridge financing instrument. However, this non-dilutive financing approach is not without its challenges. VPO financing must be repaid, and new investors typically prefer their investments to be allocated toward the company's growth rather than the repayment of existing debts. Consequently, utilizing bank financing as bridge financing for the A round presents a high-risk financing model, necessitating careful consideration of various "what if" scenarios.
It is more common for Series A bridge financing to be structured through various convertible bond or equity loan instruments. In these financing solutions, it is typical for the conversion price to be linked to the next financing round (qualified financing round) with a specific discount, such as -20%.
In this context, the valuation of the bridge financing instrument is left open, with no definitive stance taken on it. Instead, the determination of the company's valuation is deferred to the investors in the next funding round. Keeping the valuation open benefits current investors, as any statements regarding valuation can either complicate the execution of the subsequent financing round or lead to a lower valuation in that round. Typically, the instrument also includes a significant interest rate in addition to the discount for the next financing round, providing investors with a guaranteed return.
When negotiating a bridge financing instrument, it is essential to consider all possible scenarios. What if the "qualified financing round" never materializes? Or what if there is an exit before the A round is executed?
While positive scenarios are often contemplated, negative scenarios can result in loan instruments remaining on the company's balance sheet that cannot be voluntarily or contractually converted into shares. For instance, a capital loan with a 14% interest rate lingering on the balance sheet can obstruct future equity-based financing solutions, as the capital loan takes precedence over shares, and its ongoing high interest represents a continuous cost to the owners.
The most problematic instruments are those that allow investors to demand loan repayment instead of share conversion. This not only complicates the process of raising additional financing but can also push the company into a liquidity crisis. In practice, a VPO-conditional convertible bond is rarely a sensible financing instrument for a startup.
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Published 21.11.2023