Bridge Loans: How Friends Can Get You Cash When Investors Can’t

Whether your business is growing rapidly or just getting started, you need cash.  But negotiating with investors or VC can take a long time – time you don’t have.

Most entrepreneurs report that investors take 6 months or more to write a check. You need cash NOW… not months from now when investors have finished picking apart your business plan and negotiating deal terms.

To get money in the door more quickly, entrepreneurs are turning to “bridge loans“.  The idea is not new, but recently it has come into wider use by emerging companies and angel investors (I’ve even seen it used on Shark Tank!).  The new popularity of bridge loans is due to their simplicity and speed.  A bridge loan can be started and finished in just a few hours or days… giving you the cash you need to “bridge” the time until a big investor or VC makes up his mind and writes a check.

How simple is it?  A bridge loan can be documented on one page — it is an agreement to borrow money now and decide other terms later.  Until the terms for an equity deal can be hammered out, the money is considered a loan to the company and earns interest.  Later, when equity investors (like VC) negotiate terms to purchase stock, bridge loans usually convert to stock under the same (or very similar) terms.

In short, a bridge loan is a promise 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 (NOW!) and when professional investors can negotiate a fair valuation for stockholders.

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

• Value:  Loans are ‘cheap’ compared to equity (stock).  Plus, using loans to grow the business can greatly increase the value of the company before the equity deal is done.
• Size:  The business can accept smaller amounts of capital than would be feasible in an equity round.
• Flexibility:  A simple agreement between the company and an individual (e.g. Angel investor) does not require the complexities of typical bank loans or equity transactions.
• Security:  Loans can be secured by an asset (like equipment) and only convert when the company is on a firm growth path.
• Friendly:  Take a loan from your mom or best friend with the knowledge that they will get the benefit of a professional investor negotiating the eventual equity value of their money.

Keep in mind that not everyone is familiar with – or comfortable with – a bridge loan. Some experienced angel investors will say that it’s like buying a home without knowing the price.

But the angel investors (or friends) benefit too.  In addition to interest on their money (before conversion), they might also receive other benefits, like a “discount” on the VC-negotiated terms.  In other words, they might receive $12,000 worth of equity for each $10,000 invested. Another bonus for angels might be a “grant of warrants”.  This could give that same $10,000 investor the option to purchase another $5,000 worth of stock at the same price, but at a later time – perhaps as much as 5 years later.  All these terms reward the angel investors for the additional risk they take by loaning the money quickly.

The Risks
There are dangers to overly aggressive bridge loans.  In particular, if a future equity round never happens, angels may be stuck with a loan.  Be sure you are building a true bridge – and not just a long pier.

Even if a professional venture capitalist (VC) or private equity buyer does eventually negotiate an investment, bridge loan terms can be called into question.  VC may complain that the bridge terms are too generous.  Fortunately, loan holders are usually anxious to have the strength of a VC investment and are willing to bend a bit when it comes to negotiating final conversion terms.

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.  Your rich uncle who has no idea how to negotiate for equity can put money in now and feel comfortable that the negotiations will be handled by a more sophisticated (and objective) investor later.

Occasionally, but not often, convertible loans are even used by VC to tide over a company between two rounds of funding.  That’s the exception, not the rule; very few professional investors will take this shortcut to funding.  But stay tuned, that could be the next big trend!

Dedicated to your (Bridge To) Profits,

David

PS: Please Tweet or link to this important story so other small business owners can learn about this great way to raise money.