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 Stone Gate Partners LLC, a private equity investment bank in Boston.
Wolfe says he needs to be 90 percent 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 US$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."
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 Stone Gate'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 percent and 11 percent 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 percent to 30 percent 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 percent and 80 percent 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.