Traditional equity financing can be very helpful for certain businesses in need of capital, but may not offer the best fit for all. An innovative hybrid instrument, called mezzanine financing, can be particularly appealing for SMEs that are not suitable for public listing or who are reluctant to give up the control that comes with venture capital.
Mezzanine capital is a hybrid-financing instrument that allows a company to issue debt that can have a variety of structured terms such as periods of interest only, a blend of interest and equity or profit sharing added return options, and in some cases equity convertibility. These loan structures can involve collateral for firms with less robust cash flows or even little or no collateral for strong cash flowing companies. Outlined below are some of the major differences between mezzanine financing and traditional equity investment.
Mezzanine finance vs. equity investment
- Venture capitalists are willing to accept a relatively high rate of failure and search intensively for companies that will attain extraordinarily high rates of return in order to boost average returns. On the other hand, in mezzanine finance, firms are not expected to achieve highly elevated levels of internal rate of return, but rather sustained growth.
- Equity investors often require significant changes in governance and company control as providers of financing expect to play an active role in guiding the development of the company. In contrast, mezzanine financing does not imply relinquishing control and is more closely based on traditional bank loan covenants.
- In venture capital finance, the investor is willing to provide financing to firms with negative cash flow while demanding higher rates of return in exchange. Instead, mezzanine finance is most frequently used in a later or expansionary phase of the firm, after the company has attained profitability.
- Venture capital finance is often undertaken with the assumption that the firm will not achieve positive cash flow for a certain time and will thus require several rounds of financing. Conversely, Mezzanine finance implies an obligation for the firm to pay interest promptly and eventually to make additional payments linked to agreed upon repayment terms and in many cases additional returns tied to the performance of the company.
Although mezzanine financing is geared towards firms that are profitable, there are some unique cases in which it can be useful when approaching the expansion stage, but still incurring a negative cash flow. If investors are convinced that there is a reasonable likelihood the firm will achieve sufficiently strong cash flow relatively quickly, they may be willing to accept comparatively small interest payment early in the life of the mezzanine facility with a larger share of interest and equity repayments occurring in the latter stages.