What is Bridge Financing?
Bridge financing is defined as the method of financing which helps in the procurement of short-term loans to cater to immediate business requirements until long-term financing is secured. Bridge loansBridge LoansA bridge loan is a short-term financing option for homeowners looking to replace their current home and pay off their mortgage either by paying interest on a regular basis or by paying a lump sum interest when the loan is paid off.read more or finance are procured to cater to the working capital needs of the business or to solidify any short-term business requirements. They have high finance costs or rates of interest.
These financing methods bridge the time frame when the business is facing a cash crunch and the business 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
The bridge financing can be arranged in the form of high-interest debt. These debts are basically for a short-term time frame. Such loans 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
The bridge financing can be used before the initiation of the initial public offeringInitial Public OfferingInitial Public Offering (IPO) is when the shares of the private companies are listed for the first time in the stock exchange for public trading and investment. This allows a private company to raise the capital for different purposes.read more. Such loans may be used to cover for the floatation costs that arise from the initiation of the initial public offering. The floatation costs are costs born 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 arrangement of bridge financing ensures that the time 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 are fixed between the lender and the borrower. These types of arrangements ensure that loans are serviced in a timely manner. This type of arrangement is bind through a legal contract.
#4 – Open Bridge Financing
In this variant of bridge financing, the time period for servicing the loans are not fixed. This arrangement cannot guarantee the timely servicing of loans.
#5 – First & Second Charge Bridge Financing
In this type of loan arrangement, the lender demands a first charge or second charge corresponding to the collateral basis in which the bridge loans are being procured by the business. If the lender demands 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, then the lender would have the second right towards the collateral in the event of defaults made by the business.
Bridge Financing Examples
- Business is currently under severe cash crunch but it has provided with a new business opportunity. They have a $600,000 shortfall required for the purpose of initiating a new business project. They approached the nearest venture capitalist for the purpose of bridge financing.
- The venture capital assessing the business opportunity and the 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 derived from it approves bridging finance. He agrees to finance but at a high cost of 15% rate of interest with the loan being serviced from one year of the disbursement of the loan.
- Suppose a business about to go into the initial public offering. However, there are approximately three months to initiate the initial public offering. The business requires an additional $1,000,000 cash to maintain the operations of the business.
- The business, therefore, has approached the underwriter that is currently working on the Initial public offering of the business. The underwriter 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 given.
Bridge Financing Numerical Example
Suppose an individual has an old residential property that he wants to dispose of the property is under the mortgage 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 for $2,200,000 wherein it can procure finance up to $1,000,000. The individual still has some deficit amount to meet up the purchase of the property which can be financed through a bridge financing arrangement.
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 in improving the credit profile for those who have a bad credit profile if the entity ends up servicing timely loan payments throughout the loan tenure.
- It helps in quick finance for pursuing auctions and immediate business needs.
- The terms and conditions involved with bridge loans depend on the flexibility of the lenders.
- It helps the borrower to manage its payment cycles.
Disadvantages
- The bridge loans carry a high rate of interest and hence are termed to be very expensive.
- Since the loans are very expensive, they pose a high default risk from the end of borrowers.
- The lenders charge high fees on the late payments.
- For each unpaid loan, the balance keeps compounding itself with the rate of finance.
- The borrower may not be able to exit such loans as he may fail to get loans from traditional lenders.
Limitations
- The borrower with a bad credit profile may not get access to bridge loans.
- The lender may ask for collateral before providing any bridge loans to insure its loans from borrowers with a bad credit profile.
- The lender may additionally charge high fees on originations and foreclosures.
Important Points
- These are loans of short-term nature having 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 in nature that is there are no concrete covenantsCovenantsCovenant 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 lender and borrower.
Conclusion
The bridge financing is the method to arrange finance to bridge short-term business requirements. These are normally employed to finance the working capital needs of the business or acquire any tangible assetsTangible AssetsAny physical assets owned by a firm that can be quantified with reasonable ease and are used to carry out its business activities are defined as tangible assets. For example, a company's land, as well as any structures erected on it, furniture, machinery, and equipment.read more. Bridge financing is also employed for the purpose of IPOs as well as financing of good deals. It ensures that the borrowing entity does not miss out on good, lucrative, and comprehensive business deals.
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