How mezzanine capital works

Venture capital is more difficult to obtain, and a bank loan for start-ups anyway. Mezzanine capital, as a hybrid between equity and debt capital, could be interesting for founders. But is it worth it?

There are many different options for start-ups to raise money. Traditionally, a distinction is made between debt and equity capital. Debt capital is, for example, credits and loans that are usually provided for a limited period of time and are repaid at some point. Equity capital is, for example, the classic venture capital that a start-up receives in exchange for shares in the company and which it generally does not have to repay.

In fact, however, there is also a third option: mezzanine capital. This term refers to several forms of financing that are somewhere between debt and equity. Enpal, for example, recently used such a model. Ideally, anyone who secures mezzanine financing can combine the best of both worlds. However, there are a few things to keep in mind. An overview.

What is mezzanine capital?

Mezzanine capital, also known as hybrid capital, can take many different forms. Among other things, profit participation certificates, dormant equity holdings, convertible bonds and shareholder loans fall into this category. The options for structuring mezzanine capital are extremely variable, and the contracting parties can let off steam as far as possible with regard to terms, termination and repayment modalities, and profit sharing.

Nevertheless, there are some criteria that apply to almost all forms of mezzanine capital. For example, they are usually subordinated, which means that mezzanine capital providers are only serviced after all other creditors should insolvency occur. The term is usually relatively long; five years or more are normal. In addition, the interest rates - if agreed - are often relatively high, as the mezzanine modalities expose the financier to a higher risk.

Of course, mezzanine capital also has to be accounted for somehow. Accordingly, founders must make a decision in the balance sheet as to whether to enter their mezzanine financing under equity or under liabilities. A rule of thumb: If it is a mezzanine loan, it must be booked as a liability. If this is not the case, founders better check the box under equity.

If the mezzanine capital is treated like equity - for example, in the case of a silent partnership - it often has the pleasant side effect that it polishes up the credit rating and gives the start-up the opportunity to obtain loans on better terms. Thus, mezzanine financing can be the starting point for a mixed financing round.

What forms of mezzanine capital are there?

There are hardly any limits to the imagination when it comes to mezzanine financing, but some forms have become established.

First of all,subordinated loans are nothing more than "normal" loans: The capital provider makes money available for a certain term, receives interest for this time and his money back at the very end. The catch: if the borrower has to file for insolvency in the meantime, the subordinated loan takes second place to all other creditor claims. So if there is no money left at the end, the subordinated lender is pinched. However, the interest rates are significantly higher than for other loans. The lender does not have any co-determination rights in the company.

Shareholder loans are also considered mezzanine capital. Loans that the shareholder gives to his company are initially treated no differently than loans from other capital providers. Here, too, an important difference becomes apparent in the event of insolvency. Under certain circumstances, the loan can be treated as an equity-replacing loan. This means that, like equity, it is not repayable to the shareholder. This type of loan is not possible in the case of a partnership (e.g. GbR or KG).

While these two mezzanine forms are treated as debt capital, at least initially, the silent partnership is considered equity capital. The dormant partner waives co-determination rights, but participates in the profits. He does not have to be entered in the commercial register and generally does not appear externally, hence the term silent. In theory, they can also participate in losses up to the amount of their contribution, but in practice this is usually excluded by contract. In the event of insolvency, the silent partner is a regular creditor.

Closely related to dormant partner's interests are participating loans. These are loans whose interest is dependent on profits or sales. As with the silent partnership, the investor has no say in the matter. However, he acts as a creditor from the outset and is therefore protected against loss participation.

Profit participation rights are issued by the start-up itself. Anyone who acquires them participates in the company's profits. The big difference between this and, for example, a participating loan: This participation also applies to the company's loss. Profit participation rights usually have an end date at which the buyer gets back the money he invested, provided it has not been used up by the company's losses. If the profit participation right is securitized as a security, it is referred to as a profit participation certificate.

Last but not least, there are convertible bonds . These basically function like normal bonds and earn the buyer interest over the term. However, at a certain point in time - usually at the end of the term - the holder of the convertible bond can choose to exchange it for a predetermined number of shares instead of receiving his capital back. Option bonds work in a similar way. With them, the bondholder can purchase a certain number of shares at a fixed agreed price. However, he still gets his money back at the end of the term.

For whom is mezzanine capital worthwhile?

In principle, mezzanine financing can be worthwhile at any stage of a company's life cycle when high levels of investment are required, for example in product development, production expansion or expansion. They provide liquid funds in the short term, have a low impact on creditworthiness due to their structure, and enable founders to retain control of their company. If the investor's remuneration is linked to the company's performance, this also reduces the financial risk.

However, since many mezzanine financings involve a regular payment to the capital provider - for example in the form of interest - the company should have a constant cash flow from which it can finance them. In most cases, interest rates are relatively high because the financiers are taking on a high level of risk. This is disadvantageous. And: The money has to be paid back in the end. Especially if the planned investment or expansion does not pay off by then, this can be painful.

Who provides mezzanine capital?

The most important players in the mezzanine market are specialized mezzanine funds such as the Micromezzanine Fund of the German Federal Ministry of Economics and Technology or M-Cap Finance Funds. The investment companies of the federal states also often issue mezzanine financing. Crowdinvesting is one way to obtain subordinated loans. Private equity firms are also often willing to engage in financing on such terms. Mezzanine capital does not play a role in the traditional banking market.