Use Bridge Loans to Link Periods of Rapid Growth

Whether your business is growing rapidly or just getting started, equity investment from venture capital funds or other private equity groups can take time -- time you don’t have.

The primary reasons are that VCs and other institutional investors spend weeks, sometimes months, negotiating deal terms. And even when terms seem set, the final investment decision is generally made by committee, which can further delay the delivery of a check.

To get money in the door more quickly, some business owners combine the decisiveness of an angel investor with the simplicity of a convertible note, or “bridge loan.”

A bridge loan simply allows a company to accept an investor’s check at terms that will be decided later. Until the terms for an equity deal can be hammered out, the money is considered a loan to the company and earns interest. Bridge loans from friends or angel investors leave the equity deal terms open to future investors. The hope is that those future investors, such as VC or private equity groups, will have more expertise at negotiating such things.

Bridge loans also require a leap of faith by the angel investor because future equity rounds sometimes do not happen. With that in mind, the bridge loan terms should be good enough to stand on their own, just in case.

In short, a bridge loan is a promise (from you to an investor) to convert borrowed money into company stock at a price to be determined later. It “bridges” the time between when the company needs the money and when it can establish a fair stock price, or valuation, with professional investors.

The Benefits

Because bridge loans are fast and simple, many angel investors and angel groups are using them more often. With the right terms, most investors will agree to a bridge loan even if it is not their first choice.

Besides being fast and simple, bridge loans offer several other benefits:

• Value: Using loans to grow the business can increase the company’s value before the equity is sold.
• Size: The business can accept smaller amounts of capital than feasible in an equity round.
• Flexibility: Because they are essentially a simple agreement between the company and an individual, you will not face the kind of complicated conditions you might find with a bank.
• Security: Loans can be secured by an asset (e.g., equipment) and only convert when the company is on a firm growth path.

Keep in mind that not all investors are familiar with, or comfortable with, bridge loans. Some inexperienced investors might say it is like buying a home without knowing the price. But there are benefits for the investors, too. In addition to interest on their money (before conversion), they might also receive a “discount” on the VC-negotiated terms. For example, they might receive $12,000 worth of equity for each $10,000 invested.

A third bonus for angels can be a “grant of warrants,” as explained in Warrants: What They Are and How to Use Them. This could give that same $10,000 investor the option to purchase another $5,000 in stock at the same price but at a later time, perhaps as much as five years later. All these terms reward angels for the additional risk they take by investing early.

The Risks

There are dangers to overly aggressive bridge loans. In particular, if a future equity round never happens, you may be stuck repaying a large loan. Be sure you are selling a true bridge, and not just a long pier.

Even if a VC does eventually negotiate an investment, bridge loan terms can be called into question. VCs may complain that the bridge terms are too generous. When that happens you and the bridge loan holder will have to negotiate with the VC. Fortunately, everyone generally wants to have the strength of a VC investment, so finding common ground is not hard.

The Best Fit

If your investors are less sophisticated, this is the perfect way to keep the investment terms fair and equitable. If you accept family money in particular, you should consider a bridge note. Just be sure to have the note drawn up by a reputable securities attorney. The concept is simple, but it still touches on matters of state and federal securities laws, so it pays to do it right.