A bullet loan (also called a balloon loan) is a slightly different type of loan that a startup can receive, and it’s a little bit unusual. Bullet loans are usually used in the late-stage startup sector and also in the biotech sector, but they’re still fairly uncommon, so let’s look into what a bullet loan actually is.
Normal Loans Vs. Bullet Loans
To understand what a bullet loan is, it’s helpful to know what a normal loan usually looks like for a startup company.
Normal Loans
Typically, a normal venture debt loan will have an interest period of 6-12 months and then they will amortize the principal every month until the term is over. This means somewhere between a 30-36 month overall loan period. Every month in that amortization period, you’re paying a little bit of principal to bring the total principal outstanding down, in order to eventually pay the loan off entirely.
Lenders like that type of structure of loans for startups because of the inherent risk a startup poses in comparison to a normal cash-flow positive business when paying back a loan. Lenders like to take some of the outstanding loan money ‘off the table,’ so to speak, every month, because it gradually reduces the overall risk. This way, by the time the startup may run into any trouble, the lenders have hopefully collected a chunk of their cash back.
For startups, this is not as ideal a structure as it is for the lenders. This is because startups want access to as much money for as long as possible. They want to be reinvesting that debt into other areas such as research and development.
Startups want loans which allow cash to be available as long as possible with a payback that is as low as possible until the end of the loan term.
So startups want to pay back as little of the loan as possible in the early part of the loan period, and that’s why bullet loans were developed.
Bullet Loans
A bullet loan offers a different repayment structure to startups. They only require a very nominal amount of principal repayment throughout the loan’s term - sometimes zero. Then, say 3-5 years down the line, the startup is required to pay the outstanding balance in full.
Now it’s important to think about the gravity of that. On the last day of that loan’s term, all the money borrowed is due to be repaid. Unlike the one small remaining amortization repayment that would be left in a usual loan, the startup will be writing a very large check. Unsurprisingly, this can frequently create a problem for the startup.
Bullet Loans Are Aggressive But Functional
Bullet loans are very aggressive. If the startup with the bullet loan is not in the best financial shape, it won’t be easy to get that big chunk of cash together to pay that loan back.
It’s actually pretty common to see these kinds of loans in biotech. However, it’s also common to restructure the terms as that maturity date gets closer and the startup often realizes they don’t have the cash to pay it.
For lenders who do bullet loans, the loans are almost closer to an equity-like instrument rather than traditional venture debt. This is because there’s often an expectation that a lot of these loans are going to have to be restructured and the lender’s going to have to play ball. However, in return for that restructure, the lender will often get a lot more warrants or equity in the company. So a bullet loan is a riskier loan.
They can be more favorable and helpful for the startup, but the lender is taking a lot of risk.
Pros And Cons of Bullet Loans
Bullet loans can be useful in specific situations, but they come with considerable risks that require careful consideration and planning.
Pros:
- Lower monthly payments. Since only interest payments are made during the loan term, the monthly payments are significantly lower compared to traditional loans.
- Improved cash flow. Lower monthly payments can free up cash flow, which can be particularly beneficial for startups that need liquidity for other investments or expenses.
- Flexibility in principal repayment. Startups with bullet loans have the entire loan term to manage their finances and can plan for the large principal payment at the end. This can be advantageous if they anticipate a large influx of cash, such as the sale of an asset or a business.
- Short-term financing solution. Bullet loans can be a good option for short-term financing needs, where the startup knows they will have the funds to pay off the principal at the end of the term.
Cons:
- Payment shock. The requirement to pay off the entire principal in one lump sum can be risky. If the startup doesn’t have the funds, they may face default.
- Refinance risk. As we mentioned, startups often rely on refinancing the loan at the end of the term. If refinancing is not possible due to market conditions or changes in creditworthiness, the startup could face financial difficulties.
- Accrued interest. Although the monthly payments are lower, the total cost of the loan might be higher due to the accumulation of interest over time without reducing the principal.
- Careful financial planning is necessary. The need to make a large payment at the end of the loan term requires careful financial planning. Any mismanagement or unforeseen circumstances can result in significant financial problems or default.
Bullet Loans Can Be A Win-Win
The risk of restructuring posed by startups generally means the lenders will be compensated in the form of equity in the company, or high interest rates. Even so, a bullet loan can be a classic win-win.
These compensations are likely a cheaper way to raise capital for the startup than than more venture capital financing. The lenders that offer bullet loans, especially in the biotech space, are very, very good. They think like equity investors and they underwrite like equity investors. All of this is why bullet loans have become a lot more popular in the last ten years.
The startup’s board of directors and management must handle the loan responsibly. Make sure you read and understand the venture debt term sheet before you agree to it! Everyone must keep in mind that you may have to restructure this loan down the road, and so you better have a really good relationship with your lender. You want:
- Full transparency
- Clear communication
- A good working relationship
- An understanding that a loan restructure may be necessary
If you have any other questions on bullet loans, valuations, startup accounting, or taxes, please contact us. You can also follow our YouTube channel and our blog for information about accounting, finance, HR, and taxes for startups!
