When Should You Use a Business Bridge Loan?
What are business bridge loans and why are they so commonly used by business owners as a financing solution? A business bridge loan is defined as: a short-term loan or other type of funding that provides the capital a business owner needs to cover immediate expenses and gives the business owner enough time to locate a longer-term answer to their company’s financial situation.
For a small business owner, any interruption in cash flow can be a huge problem for their business. It’s usually in these cases that an entrepreneur can find the answer in the form of a bridge loan. For entrepreneurs who need a financing solution to get from Point A to Point B and don’t have the cash on hand, these loans are often a lifeline.
Any loan of any kind can be considered a bridge loan if it can be secured promptly and answers a need for cash right away while awaiting a bigger windfall down the road. A bridge loan for a business can help a company owner get his or her hands on cash in an expedient manner when there is a shortfall in cash or when certain large expenses need to be paid right away.
While the term “bridge loan” is sometimes associated with home buying, it’s also applicable to the operation of a business. Sometimes, a business owner has to secure a bridge loan in order to continue operating on a day to day basis and pay the bills while awaiting greater long-term capital that has not arrived yet. According to the U.S. Chamber of Commerce, bridge loans can be critical to a business that is in a cash-flow lull when it has yet to get the longer-term funding it is awaiting to pay expenses.
What Makes a Business Bridge Loan Unique?
The time required to apply for, get approved and start to receive funds through a private lending source is much shorter with a business bridge loan than it is for a conventional business loan, especially a bank loan.
The business owner to opts to seek a bridge loan instead of financing through a bank often does so because the application process is less complicated and the funding that is offered is usually more expedient by comparison.
The down side is that the interest rate on a bridge loan tends to be higher, and there also are higher fees involved. That’s a tradeoff that some business owners are willing to endure due to the shorter duration of the loan, which is usually to be paid off in no more than 12 months’ time.
Interest rates on a bridge loan are directly correlated to the level of risk perceived to be involved with the financing. The interest rate on a bridge loan from a private lender could range anywhere from 8 percent to 12 percent. As far as fees are concerned, bridge loans often entail fees that are expressed as “points.” Each point represents a percentage point of the loan amount, so a bridge loan in the 3-point range translates into 3 percent of the loan amount.
Depending on the lender, some other fees might also be added for processing documents or underwriting.
Common needs for a bridge loan
A small business might consider a bridge loan to keep the company solvent and able to pay its bills during a time when cash on hand is scarce but invoices that are outstanding are on their way to being paid off. It is also possible that the business might be in the market for new real estate, but lacks the time required to go through the process of securing a mortgage. This is a particularly common situation, as many business owners will turn to a commercial real estate bridge loan when looking to acquire new property or office space.
Bridge loans can also make sense when a company is trying to gain investment or has a pending round of fundraising. If a company is raising a round of equity financing, it might not be able to realize those funds for a period of months while the deal is still being worked out. A bridge loan provides the working capital the company needs to get through that period until the fundraising is secured.
Many retail businesses take advantage of bridge loans to purchase inventory, which requires considerable up-front costs to cover before the company turns around, sells those products and is able to make a profit on them.
Is a bridge loan a good idea for a small business?
It very well could be for a company seeking financing to meet payroll and payroll tax requirements, to ease the tension caused by clients who haven’t paid off their invoices from the business yet, to pay off a tax lien, or to pay vendors and maintain inventory.
A business that intends to expand more rapidly, to acquire another property or to undertake other strategic acquisitions, could also seek a bridge loan. A bridge loan intended to cover expansion plans answers the need for capital, so that a growing company can hire more employees, search for more spacious accommodations or renovate and expand present space, and buy the time needed to expand.
Some businesses commonly experience seasonal lulls: An ice cream parlor or a seaside restaurant in the winter, or a ski resort or ice skating center in the summer. Bridge loans could be appropriate funding solutions for all of these needs, as well as to simply buy one some extra time while seeking out longer-term financing.
The need for working capital could be the impetus to apply for a bridge loan. Working capital is the difference between the current assets a company has, including cash and accounts payable, and its current liabilities, which would include bills that need to be paid, salaries and any debts. If a business has more present liabilities than current assets, the cash shortfall that could result might prompt a business owner to seek a bridge loan.
Another less common, but extremely valid, reason a business might seek a bridge loan is to recover after an unforeseen catastrophe. A restaurant whose basement flooded during a massive hurricane will need to get back on its feet quickly to stay in business. The Small Business Administration of the United States government may offer low-interest bridge loans to companies that face such dire predicaments. The interest rate on this kind of bridge loan, or one from a state government, is not likely to be as high as other types of bridge financing.
Advantages and Disadvantages of Bridge Loans
Spelling out more clearly some of the advantages and drawbacks of bridge loans can better help the borrower decide whether a bridge loan is a good solution.
Advantages of a bridge loan include:
- Rapid funding: A business owner who does get approval for a bridge loan will then benefit from virtually immediate access to the money he or she needs. Instead of waiting months for the coverage that is needed right away, the borrower can usually count on being funded in as little as a week’s time.
- Short terms: A bridge loan is usually made with the understanding that it will be paid off within a year or less. Not being saddled with long-term debt on this kind of financing can ultimately be very liberating for the business owner, especially since the loan was secured with the intent that a more copious cash flow will be forthcoming, expediting the settling of the debt.
- Ease of application: A small business bridge loan application may be as brief as a single page or even less than that. These applications may only include rudimentary queries of business owners to determine loan eligibility.
- Choice of repayment methods: The borrower has the freedom to decide whether he or she will pay the loan off either before or after the long-term financing is in place.
- An opportunity to build a better credit score: Paying off a business bridge loan on time is one method of boosting a person’s credit score if it is problematic. Building a better personal credit score can actually improve a business owner’s chance of getting a business loan on better terms in the future, too.
Disadvantages of a bridge loan include:
- The challenge of securing the loan: A typical bank may not easily agree to the terms of a bridge loan. The borrower requires equity and a credit history that are both beyond reproach. The business owner seeking a bridge loan also needs to have a debt-to-income ratio that is low. The bank needs to see the borrower as a worthy risk before granting this kind of financing, and that often is not a guarantee.
- Terms of a business bridge loan are not cheap: Interest rates and transaction fees for bridge loans can be pretty exorbitant, even more so if the borrower is unable to pay the financing off quickly. That will only make the interest soar on such a loan. Bridge loan fees are higher than fees for other types of financing. That is the price you pay for the lender’s flexibility and expediency. Because the nature of a bridge loan is not the same as conventional loans, it’s best not to compare the rates for such loans against the market rate at a given time. If cash right now enables one to keep the business going and/or to keep it growing, its long-term benefits should offset the short-term disadvantages.
- Risk: Can the business owner who borrows money with a bridge loan ensure that the cash flow that is absent now will start gushing by the time the loan needs to be paid off? The answer to that question can be vital to the survival of the small business and the financial reputation of the business owner. If, for some reason, the influx of cash that the borrower is expecting does not happen, the borrower is still stuck having to pay off the bridge loan. An inability to do so could have long-term ramifications for the status of the company and the credit rating of the entrepreneur.
Secured vs. unsecured bridge loans
With a secured bridge loan, your loan would need to get backed by company assets valued at or above the loan amount you’re borrowing. If you default on your loan your lender will seize the assets you’ve backed the loan with.
With unsecured bridge loans, backing your loan product with assets is not required. Instead of relying on assets, lenders will look at other factors relating to your company to determine your eligibility such as your provable income.
Sources for bridge financing include banks, credit unions and other private financing companies. Wherever a business owner goes for a bridge loan, that same source might be his best bet for permanent financing at a future date. Going back to the same lender with future financing requests could enhance the likelihood of a borrower securing a more favorable loan down the road.
It’s important to know that a large percentage of interim financing deals are made through hard money lenders, rather than credit unions or commercial banks. Hard money lenders are less well-known to most business owners, and working with them can carry unique kinds of risks since they are not regulated in the same way that banks and other business financing companies are.
Types of bridge loans
Bridge financing can be separated into four different types: open bridging loans, closed bridging loans, first-charge bridging loans and second-charge bridging loans.
A closed bridging loan, which is mutually agreed on by the lender and the borrower, is available for a predetermined amount of time frame. This type of financing is advantageous to the lender, who has a better chance of seeing the loan repaid on time with no issues. Closed bridging loans usually involve interest rates that aren’t as high as open bridging loans. Any loan with a clearly delineated “exit strategy” is considered a closed bridging loan.
Open bridging loans do not start out with clearly defined methods of repayment or a hard payoff date. Lenders often deduct the loan interest from the advance on the credit as insurance on the security of their funds. Borrowers have more of an upper hand with this type of financing than they do with closed bridging loans, which favor the lender, because of the attendant frequent uncertainty of when their finance will become available. However, because of these factors, open bridging loans come with higher interest rates than closed bridging loans.
With a first charge bridging loan, the lender is in the driver’s seat. Failure by the borrower to repay the loan at the specified date gives the lender the option to repossess and sell the assets that the borrower put up as security. In the event of default, the first charge bridge loan lender will get its money before other lenders do. This type of loan must be repaid on time in full to avoid the lender taking possession. “If even a small portion of the loan is left outstanding, the lender has the option of reclaiming and selling the property in order to make their money back,” according to bridging.com. Interest rates on first charge bridging loans are relatively low.
Second charge bridging loans involve more than one lender. This method of financing is a secured loan in which short-term lending is being given toward something that already was secured with a “first charge”. In this type of financing arrangement, the lender takes the second charge after the existing first charge lender. These loans, which usually are for a period of one year or less, carry a higher risk of default, so the interest rate on them is higher. After all liabilities accrued to the first lender have been paid, the second charge bridge lender can commence recouping its payment.
Is a bridge loan right for my business?
Ultimately, a business owner’s likelihood of qualifying and being accepted for a bridging loan is going to come down to his or her perceived ability to pay that loan off on time, and that will be determined by both the borrower’s credit history and the reasons for applying for a bridge loan in the first place.
Some businesses need a bridge loan simply because they are waiting on unpaid invoices that are eventually going to come in, one way or the other. Those businesses are in a more favorable position to be approved for credit than a company struggling with operating costs for other reasons. One reason involves a lot more risk to the lender than the other does. In any case, deciding if a bridge loan is right for your company comes down to weighing the costs of funding against the benefits that your company will see. To help your small business cover short-term expenses, a bridge loan could be a smart investment in the company’s future.