Bridge Financing: When Venture Capitalists Throw Good Money After Bad

Deciding to reinvest in a company amid uncertainties is one of the most challenging choices Venture Capitalists face. One question always arises whether they are considering extending bridge financing to fund the startup to the next round, overcoming a temporary setback, or making a last-ditch effort to rescue a struggling portfolio company: "Are we throwing good money after bad?". I often tell VCs I train through the VC Career Accelerator that this is the hardest decision in Venture Capital.

In this post and its companion webinar, I delve into the intricacies of the reinvestment decision-making process, exploring the circumstances that give rise to such dilemmas, the common pitfalls VCs encounter, the resources essential for sound decision-making, and the significance of recognizing and tackling psychological biases. I emphasize that the reinvestment decision is often clouded by biases and murky reasoning, necessitating a structured approach instead of relying on gut feelings or intuition. Acknowledging and addressing one's biases is key to making well-informed decisions.

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Unraveling Bridge Financing: A Lifeline or a Pitfall?

Venture Capital bridge financing, though a lifeline for startups, can sometimes serve as an indicator of underlying distress, and at other times, potentially trigger a misallocation of valuable resources and other damaging pitfalls.

Decoding Bridge Financing in Venture Capital: Kairos Moments for Startup Survival

The term "bridge financing" is often misunderstood in the Venture Capital context, as it is also used by banks and other debt providers to designate a short-term loan extended to cover a gap in a company's finances. In Venture Capital, bridge financing is an equity injection destined to cover the startup's cash needs until a milestone is reached—typically, the next round of funding, profitability, or an exit.

It is not rare for VC firms to reinvest in their portfolio companies, a decision motivated by different situations:

• Participate in the next round of financing, when things go well
• Honor a prior commitment as the startup reaches a pre-defined milestone (following an agreement called "staged investment" or "tranching")
• Extend a short-term lifeline after unforeseen events hit, like the global Covid-19 pandemic
• Keep the startup afloat when there is a lack of progress, with Founders and VCs requiring more time to understand whether the main issues are structural or temporary

In this post and its companion webinar, I focus on the last case. The decision to extend bridge financing often presents itself as a kairos moment for Venture Capitalists. Borrowed from ancient Greek medicine, "kairos" refers to a critical, opportune moment where the action taken (or not taken) can dramatically sway the outcome. In this case, whether the startup survives or goes bankrupt.

Walking the Bridge Financing Tightrope: New Investor Concerns

The core objective of bridge financing is to bolster the startup, guiding it from its current point A to a future point B. This future might signify the next round of financing, achieving profitability, or reaching an exit.

The danger of bridge financing for a startup's stakeholders, such as Founders, employees, and Investors, primarily stems from the hesitation of new Investors. This reluctance is usually rooted in the perceived risk associated with a company in need of bridge financing.

Nobody capitalizes their business planning for a “bridge” round, so the general assumption is that the company must have significantly underperformed expectations to have arrived in this spot.

SAAS Capital (Source: blog)

Venture Capitalists and other potential investors often interpret the need for bridge financing as a sign of distress. This could mean the startup hasn't achieved its milestones, hasn't grown as projected, or has failed to secure a follow-on funding round in due time. As a result, new Investors may be wary about investing their capital in a venture that seems unstable or risky.

Investing in a startup that requires bridge financing may also indicate that the company has not yet achieved a sustainable business model or developed a clear path to profitability. This can further deter new investors who seek businesses that are on a clear trajectory to success.

Therefore, when a company seeks bridge financing, it can unintentionally signal potential problems to new Investors, making them hesitant to invest. This situation can create a challenging environment for the startup's stakeholders, as the company may struggle to secure the necessary funding to bridge the gap to the next phase of its growth.

If they want to keep the startup afloat, existing shareholders—primarily the VCs, as Founders and Angels can rarely afford to chip in—need to inject fresh cash.

Venture Capital's Slippery Slope: The Risk of Throwing Good Money After Bad

When Venture Capitalists opt to inject further capital into a struggling startup, they run the risk of throwing good money after bad. This situation arises when Venture Capitalists persist in financing a poorly performing startup, fueled by the optimistic expectation that the influx of capital will catalyze a turnaround. Unfortunately, these hopes may often go unfulfilled. If the startup's struggles are due to fundamental issues like an unviable business model, poor market fit, or mismanagement, then extra funding may not resolve these problems and may simply be wasted.

Reinvesting new money that will eventually be lost has far-reaching implications. The most immediate impact is the misuse of funds, which can adversely affect Investors' financial returns. The WeWork debacle is a case in point, illustrating the potential consequences of a failure to recognize when to step back. This cautionary tale underscores the importance of sound decision-making and due diligence in Venture Capital. (Watch the webinar for more details on this fascinating case study).

However, the monetary cost is only the tip of the iceberg. The opportunity cost associated with a bad reinvestment decision can be significant. The same funds could have been invested in another, potentially successful startup, creating more value for the portfolio. This is particularly critical given the "power law" nature of Venture Capital returns, where a small number of home runs account for the vast majority of a fund's returns.

"Maybe I should save that money for my next core investment, as opposed to an extension." Those are questions we ask ourselves all the time.

Mark Mullen - Bonfire Ventures (Source: 20VC)

Moreover, there's the cost of time spent on a sinking ship—time that could have been spent sourcing new deals, mentoring other portfolio companies, or developing further industry expertise.

The repercussions of such decisions extend beyond the direct costs. Venture Capitalists who consistently throw good money after bad may find their relationships with Limited Partners (LPs) and co-investors strained. LPs and co-investors may begin to question the Venture Capitalist's judgment, damaging trust and future collaboration opportunities.

Venture Capitalists must also consider the relational consequences of not extending bridge financing. Withholding additional funding may strain the relationship with Founders, as their startup's survival hangs in the balance. Similarly, within a VC syndicate, if some VC firms choose to commit additional funds while others abstain, the dynamics can become increasingly complex.

Considering the repercussions on relationships with Limited Partners and co-investors on one hand, and the Founders on the other, is a delicate balance to maintain. While bridge financing can provide a lifeline for startups in specific situations, it is critical for Venture Capitalists to tread carefully, recognizing the potential pitfalls of throwing good money after bad.

Why do even seasoned Investors occasionally re-inject capital to underperforming startups? Investing isn't just about crunching numbers and evaluating business models; there is a layer of psychology at play too. In the next section, I explore how cognitive biases can sneak in and potentially derail the reinvestment decision-making process.

Why Venture Capitalists Stumble: The Psychology of Decision Making

Investing is as much a psychological game as it is a financial one. Venture Capitalists operate under conditions of profound uncertainty and, in these conditions, cognitive biases often skew decision-making. These biases can cloud judgment and result in flawed decisions, particularly in the complex, high-stakes realm of bridge financing.

The Venture Capital Context Favors Cognitive Biases

I've shown in this post how Venture Capital investment decision-making opens VCs to dangerous psychological biases, systematic errors in thinking that can affect the decisions and judgments they make. These biases stem from our brain's attempts to simplify information processing. Psychological biases arouse from emotional factors, social dynamics, and cognitive processes such as perception, memory, and problem-solving. Many VC investment decisions are influenced by these biases, of which Investors are often not consciously aware.

I've detailed in another post how Venture Capital investment decision-making can expose Investors to a range of psychological biases. These biases represent systematic errors in thinking that can significantly affect the decisions and judgments they make. They arise from our brain's innate attempt to simplify information processing. Emotional factors, social dynamics, and cognitive processes such as perception, memory, and problem-solving contribute to these psychological biases. Many investment decisions made by Venture Capitalists are influenced, subtly and subconsciously, by these biases. This influence is often so discreet that Investors themselves may not consciously recognize its presence.

On top of the biases present in the initial investment decision, the reinvestment decision is fraught with specific dangers.

Even the best startups often go through near-death experiences.

Paul Graham (Source: Twitter)

Startups rarely follow a clear, upward trajectory. More often than not, they navigate through a tumultuous path laden with peaks and valleys, often coming close to failing before a sudden surge of success.

For example, Airbnb struggled to secure initial funding and faced near-bankruptcy before finally breaking through. At some point, it famously funded its cash burn by selling cereal boxes. Apple, which I mention in the webinar, is another case in point. Near-death experiences can sometimes preface the greatest successes. Discerning between a temporary setback and the early signs of failure can pose a significant challenge, even for experienced Investors evaluating reinvesting in a portfolio company.

Reinvestment decisions are shrouded in ambiguity. Understanding the distinction between uncertainty and ambiguity can shed light on why Venture Capitalists sometimes make missteps when reinvesting. Uncertainty, in this context, refers to situations with unknown outcomes, but where the probability of each possible outcome can be estimated. For instance, VCs estimate the probability of a startup's success based on factors like market size, team capability, and product potential.

In contrast, ambiguity refers to situations with unknown outcomes and where the probability of each possible outcome is also unknown, rendering any decision-making based on potential outcomes akin to a shot in the dark. For example, during the initial stages of disruptive technology, like the introduction of blockchain, it's almost impossible to accurately predict the landscape of success and failure.

In the context of reinvestment decisions, this ambiguity becomes even more complex. If a startup is not meeting its goals or if its performance is declining, it's often not clear whether this is due to temporary setbacks that can be overcome with additional funding, or if there are more fundamental issues that are less likely to be resolved.

In these cases, VCs often have to make decisions under conditions of high ambiguity, where they can't rely solely on data and have to use their judgment, experience, and instinct to make the best possible decision. The progress made since the first investment is not always conducive to clear interpretations.