For a high growth company, selling equity can be very expensive. Why?
If a company is growing its profits by 100% annually, it will have grown its profit by a multiple of x32 by the end of year 5 (a 3,200% increase).
Accordingly, if the management of that company decided to raise equity at the beginning of year 1, they would need to sell at an earnings multiple of 320x the current year’s profit to sell at a 10x multiple of profits in year 5.
Not many venture companies manage to do that and are forced to raise capital at lower multiples. If their growth projections then become reality, the equity raise will turn out to have been very expensive for the sellers.
Enter Mezzanine Financing
Mezzanine capital is hybrid financing that consists of both debt and equity exposure, which gives the lender the right to convert to an equity interest in the company at a predetermined exchange rate. Because the investor is entering with debt, his downside is better protected. As such, the investor is also willing to sacrifice his exposure to the upside.
Mezzanine financing can be a useful tool for many high growth companies in order to fuel growth at a relatively low cost of capital. Mezzanine finance specialists work with owners to design custom funding packages that aim to lower the cost of capital and mitigate excessive dilution for founders.