At the point where the company has overcome many of the early stage risks, it may be ready for mezzanine capital. The term mezzanine financing refers to capital that is between senior debt financing and common shares. In some cases it takes the form of the redeemable preferred shares, but in most cases it is subordinated debt that carries an equity “kicker” consisting of warrants or a conversion feature into common shares. This subordinated debt capital has many characteristics of debt but also can serve as equity to underpin senior debt. It is generally unsecured, with a fixed coupon and maturity of 5 to 10 years. A number of variables are involved in structuring such a loan – the interest rate, the amount and form of the equity, exercise/conversion price, maturity, call features, sinking fund, covenants, and put/call options. These variables provide for a wide range of possible structures to suit the needs of both the startup and the investor.
Offsetting these advantages are a few disadvantages to mezzanine capital compared to equity capital. As debt, the interest is payable on regular basis, and the principal must be paid, if not converted into equity. This is a large claim against cash and can be burdensome if the expected growth and/or profitability does not materialize and cash becomes tight. In addition, the subordinated debt often contains covenants relating to net worth, debt, and dividends. Mezzanine investors generally look for companies that have a demonstrated performance record, with revenues approaching $10 million or more. Because the financing will involve paying interest, the investor will carefully examine existing and future cash flow and projections. Mezzanine financing is utilized in a wide variety of industries, ranging from basic manufacturing to high technology. As the name implies, however, it focuses more on the broad middle spectrum of business, rather than on high technology, high growth companies. Specifically retailing, broadcasting, communications, environmental services, distributors, and consumer or business service industries are more attractive to mezzanine investors.
Private placements, another traditional source of financing, consist of the offer and sale of equity or debt securities which are exempt from many of the more complex federal and provincial securities laws. Private placements are an attractive source of equity capital for a startup company that for some reason has ruled out possibility of going public. If the goal of a startup company is to raise a specific amount of capital in a short time, this equity source may be the answer. In this transaction, the startup offers shares to a few private investors, rather than to the public as in a public offering. In order to qualify for any securities law exemption, most private placements are restricted to institutional investors and wealthy individuals known as accredited investors. The advantage of such an offering is that the startup is able to control its cost of capital and financing timeframe by setting the terms of the sale and selling to those parties willing to buy. In addition, the startup is able to avoid the burdensome disclosure and filing requirements required in public offerings. Obtaining a private placement, however, is generally not a viable option for a startup company to pursue. At the early stages of development, a startup company will likely find it difficult to pay the costs to retain a placement agent or investment bank to help draft a private placement memorandum and to market its securities. In most cases, a startup company will likely have to raise their initial capital from some of the other sources.