What is Bridge Financing?

Bridge financing is defined as financing that helps procure short-term loans to cater to immediate business requirements until long-term financing is secured. Bridge loans or finance are procured to cater to the business’s working capital needs or solidify any short-term business requirements. As a result, they have high finance costs or rates of interest.

These financing methods bridge the time frame when the business faces a cash crunch and is about to get capital infusion from long-term financingLong Term FinancingLong term financing means financing by loan or borrowing for a term of more than one year by way of issuing equity shares, by the form of debt financing, by long term loans, leases or bonds, done for usually extensive projects financing and expansion of the company.read more options.

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Types of Bridge Financing / Loan

#1 – Bridge Financing for Debt

One can arrange the bridge financing in the form of high-interest debt for a short-term time frame. However, such loansLoansA loan is a vehicle for credit in which a lender will give a sum of money to a borrower or borrowing entity in exchange for future repayment.read more increase the financial crisisFinancial CrisisThe term “financial crisis” refers to a situation in which the market’s key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more and woes of the business.

#2 – Bridge Financing IPOs

One can use the bridge financing before initiating the initial public offeringInitial Public OfferingAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange.read more. Such loans may cover the floatation costs arising from the initial public offering. The floatation costs are costs borne by the business for undertaking the services of underwritingUnderwritingThe underwriters take the financial risk of their client in return of a financial fee. Market Makers like financial institution and large banks ensure that there is enough amount of liquidity in the market by ensuring that enough trading volume is there.read more to initiate the process of IPOs.

#3 – Closed Bridge Financing

This bridge financing arrangement ensures that the period for servicing the loansServicing The LoansLoan Servicing is a process in which entities known as loan servicers perform various administrative tasks related to loan repayments on behalf of the lender or loan originator (banks or other financial institutions), such as collecting interest and principal, paying insurance and taxes, and posting statements on a regular basis to the loan borrower in exchange for a predetermined fee.read more is fixed between the lender and the borrower. These types of arrangements ensure that loans are serviced on time. This type of arrangement is bound through a legal contract.

#4 – Open Bridge Financing

In this variant of bridge financing, the period for servicing the loans is not fixed. Therefore, this arrangement cannot guarantee the timely servicing of loans.

#5 – First & Second Charge Bridge Financing

In this loan arrangement, the lender demands a first or second charge corresponding to the collateral basis on which the business procures the bridge loans. If the lender orders the first charge, then the lender would have the first right towards the collateral in the event of defaults made by the client. If the lender demands the second charge, the lender would have the second right toward the collateral if the business defaults.

Bridge Financing Examples

  • Business is currently under a severe cash crunch, but it has provided a new business opportunity. However, a $600,000 shortfall is required to initiate a new business project. So they approached the nearest venture capitalist for bridge financing.The venture capitalVenture CapitalVenture capital (VC) refers to a type of long-term finance extended to startups with high-growth potential to help them succeed exponentially. read more assessing the business opportunity and its profitabilityProfitabilityProfitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company’s performance.read more approves bridging finance. Accordingly, he agrees to finance but at a high cost of 15% interest rate, with the loan being serviced from one year of the disbursement of the loan.Suppose a business is about to go into the initial public offering. However, there are approximately three months to initiate the initial public offering. The company requires an additional $1,000,000 cash to maintain the business’s operationsBusiness’s OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company’s goals like profit generation.read more.The business, therefore, has approached the underwriter currently working on the initial public offering of the business. The underwriterUnderwriterAn underwriter is an individual or an institution who is involved in the act of underwriting the issue of securities of a company for a fee.read more agrees to finance the bridge provided the company provides its shares to the underwriters at a price lower than the issue price but equivalent to the amount of the bridge.

Bridge Financing Numerical Example

Suppose an individual has an old residential property that he wants to dispose of. The property is under the mortgageMortgageA mortgage loan is an agreement that gives the lender the right to forfeit the mortgaged property or assets in case of failure to repay the borrowed sum and interest.read more, and the closing costs would range around $20,000. The old property is valued at $1,200,000 and has a pending balance of $300,000.

The individual plans to buy a new residential property amounting to $2,200,000, wherein it can procure up to $1,000,000. The individual still has some deficit amount to meet up the purchase of the property, which one can finance through an arrangement of bridge funding.

The following would be the deficit amount as displayed: –

Therefore, the business immediately requires a bridge loan of $320,000 to acquire the new property.

Advantages

  • These loans are processed very quickly and instantly.They can help improve those with a bad credit profile if the entity serves timely loan payments throughout the loan tenure.It helps in quick finance pursuing auctions and immediate business needs.The terms and conditions of bridge loans depend on the lenders’ flexibility.It enables the borrower to manage its payment cycles.

Disadvantages

  • Bridge loans carry a high-interest rate and are very expensive.Since the loans are costly, they pose a high default risk Default RiskDefault risk is a form of risk that measures the likelihood of not fulfilling obligations, such as principal or interest repayment, and is determined mathematically based on prior commitments, financial conditions, market conditions, liquidity position, and current obligations, among other factors.read more from the borrowers’ end.The lenders charge high fees for late payments.The balance keeps compounding CompoundingCompounding is a method of investing in which the income generated by an investment is reinvested, and the new principal amount is increased by the amount of income reinvested. Depending on the time period of deposit, interest is added to the principal amount.read more with the finance rate for each unpaid loan.The borrower may be unable to exit such loans as he may fail to get loans from traditional lenders.

Limitations

  • The borrower with a bad credit profile may not access bridge loans.The lender may ask for collateral before providing bridge loans to ensure borrowers with bad credit profiles.The lender may additionally charge high fees on originations and foreclosuresForeclosuresForeclosure refers to the legal action taken by the lender when the borrower fails to repay the amount due against the mortgage loan. The lender can take the possession of mortgaged asset or property or resale it to a third party for recovering the default loan amount.read more.

Important Points

  • These are short-term loans with a time frame of 3 weeks to 12 months.The loans are repaid once finance is arranged from the existing arrangement.Since the cost of lending is high for such loans, these loans are refinanced from the traditional lender.These loans are not regulated under any main regulatory body.Such loans are non-standard. There are no concrete covenant CovenantsCovenant refers to the borrower’s promise to the lender, quoted on a formal debt agreement stating the former’s obligations and limitations. It is a standard clause of the bond contracts and loan agreements.read more arrangements between the lender and borrower.

Conclusion

Bridge financing is the method of arranging finance to bridge short-term business requirements. These are normally employed to finance the business’s working capital needs or acquire tangible assetsTangible AssetsTangible assets are assets with significant value and are available in physical form. It means any asset that can be touched and felt could be labeled a tangible one with a long-term valuation.read more. Bridge financing is also used for IPOs and financing of good deals. It ensures that the borrowing entity does not miss out on good, lucrative, and comprehensive business deals.

This article is a guide to What is Bridge Financing. Here, we discuss a bridge financing example, bridge loan, its advantages, and disadvantages. You can learn more from the following articles: –

  • Vendor FinancingIn House FinancingSeller FinancingWhat is Working Capital Loan?