It's
ironic that companies that least need money have the easiest time
raising it, while companies that are desperate for cash have the
most problems finding it.
This is no more evident than today, at the height of the dot-com
shakeout. Venture capital funds are still flush with cash, while a
growing number of marginal online companies are going out of
business.
But for some start-ups waiting for venture capital to flow in,
there's another source of financing that could pay the bills until
the big money arrives: bridge financing.
Not So Fast
There are quite a few companies hoping to stay alive long enough
to get that second round of financing. But the old rule holds true
here as well: The dot-coms that most need short-term money are the
ones that are least likely to get it.
"Getting bridge financing in this market - if you are a dot-com
company - is virtually impossible," says David Zale, an analyst at
Sands Brothers & Co. in New York. "If someone were asking me if
I wanted to provide bridge financing to a dot-com that might have a
good business plan but desperately needs cash, I would probably let
them go out of business."
The reason? Bridge financing lenders are in it for the short term
- they want to be certain that there's a second round of venture
financing coming.
In practice, it may actually be more difficult to get bridge
financing than it is to get second-round venture capital funding.
"We've become much more careful about assessing
'refinanceability,' " says Ken Wolfe, co-founder and CEO of
StoneGate Partners LLC, a private equity investment bank in Boston.
Wolfe says he needs to be 90% certain that a start-up will get
second-stage funding before he makes a bridge loan.
He says he also looks for a company that has a solid management
team, as well as assets that could be sold off in a worst-case
scenario.
There's still plenty of venture capital out there, Wolfe says,
and there are plenty of start-up companies that will get funded.
"Those funds have not disappeared, but the [funding] cycles have
gotten longer," he says. In addition, the venture capital funds have
begun to concentrate their investments, meaning that fewer companies
will get money.
How It Works
The way the investment cycle usually works, according to Wolfe,
is that a friends-and-family round of financing, usually totaling
between $1 million and $2 million, is followed by a first stage of
financing, typically totaling between $3 million and $5 million.
This money is used to develop the product and find the first set of
customers.
Later-stage funding generally ranges between $15 million and $25
million and is used to develop the market for the product, Wolfe
explains.
A lot of bridge financing is provided by the early-stage
investors themselves, Wolfe says.
Third-party bridge financing is a private market, so it's hard to
estimate its size. Wolfe places it at approximately $500 million per
year.
StoneGate alone provided around $30 million in bridge financing
to seven companies last year. The company says it expects to provide
about $100 million in funding this year.
One of the firms StoneGate funded was Marathon Technologies
Corp., a Boxboro, Mass.-based company whose software is designed to
prevent Windows applications from crashing.
Marathon borrowed $3 million to take it through the first four
months of last year, says Robert Glorioso, the company's co-founder
and CEO.
Then, in the first week of May, $25.2 million came from venture
capitalists.
Glorioso says that in this particular instance, investors who
loaned Marathon money through StoneGate later decided to convert the
loan into equity instead of simply reclaiming their money plus
interest. In effect, these investors were able to invest alongside
the venture capitalists.
According to Wolfe, the investors that StoneGate brings into
these deals are accredited investors - sophisticated individuals,
such as CEOs of large corporations, who have the ability and
interest to make their own investment decisions but aren't
interested in becoming angel investors and helping to run companies.
Minimum investments such as these typically run around $50,000.
"It's a good deal for everyone," Glorioso says. "The company gets
the money it needs to bridge through a slow period, and the
investors get into a deal that they otherwise wouldn't be able to
get into."
More Money
According to Andy Clapp, a partner at Brook Venture Fund LP, a
venture capital firm in Boston, the amount of bridge financing
available to companies has actually increased in recent months.
"What's driving it is the tightening within the equity market and
the difficulties that some companies - actually, many companies -
have raising that later equity round," says Clapp.
The supply is rising as the need rises, he says, with
approximately a half-dozen dedicated funds, such as StoneGate's,
already in place. In addition, other funds are getting involved in
bridge financing, as are some brokerages.
According to Clapp, bridge financing is more expensive than
taking out a loan at a bank. A typical loan could run a company
between 9% and 11% in interest per year. When factoring in the
ability to convert at least part of these investments into equity,
bridge financing can often deliver total returns in the 20% to 30%
range, he says.
The interest rates are higher than bank loans because the
investor is taking a bigger risk by lending money to a start-up.
By comparison, pure equity investors expect a return on
investment of between 40% and 80% per year, Clapp says - but their
investment could also vanish overnight.
Bridge financing is a debt and has a repayment obligation, Clapp
explains.
"Equity does not have a repayment obligation, and you pay a
premium for risk," he says.
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