Mezzanine Capital

Once your 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 stock. In some cases k takes the form of redeemable preferred stock, but in most cases it is subordinated debt that carries an equity "kicker" consisting of war­rants or a conversion feature into common stock. 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 per­centage return and maturity of five to ten 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 issuer and the investor.

Offsetting these advantages are a few drawbacks to mezzanine cap­ital as compared to equity capital. As debt, the interest is payable on a regular basis, and the principal must be repaid, 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. Since 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-tech, high-growth companies. Specialty retailing, broadcasting, communications, environmental services, distributors, and consumer or business service industries are more attractive to mez­zanine investors.

Private Placements

Private placements are an attractive source of equity capital for a pri­vate company that for whatever reason has ruled out the possibility of going public. If the goal of the company is to raise a specific amount of capital in a short period of time, this equity source may be the answer. In this transaction, the company offers stock to a few private investors, rather than to the public as in a public offering. A private placement requires little paperwork compared to a public offering, in addition to the fact that the time period for this private transaction can be shorter.

If your management team knows of enough investors, then the pri­vate placement could be distributed among a small group of friends, family, relatives, or acquaintances. Or the company may decide to have a broker circulate the proposal among a few investors who have expressed an interest in small companies.

Initial Public Stock Offerings

Commonly referred to as an IPO, an initial public offering raises capi­tal through federally registered and underwritten sales of the company's

shares. Numerous federal and state securities laws and regulations gov­ern these offerings; thus, it is important that management consult with lawyers and accountants who are intimately familiar with the current regulations.

In the past, such as during the strong bull market for new issues that occurred in 1983, 1986, 1992, and 1996, it was possible to raise money for an early-growth venture or even for a start-up. These boom mar­kets are easy to identify because the number of new issues jumped from 78 in 1980 to an astounding 523 in 1983, representing a jump from about $1 billion in 1980 to about twelve times that figure in 1983 (see Exhibit 5.9). Another boom came three years later, in 1986, when the number of new issues reached 464. Although 1992's number of new issues (396) did not exceed the 1986 performance, a record $22.2 bil­lion was raised in IPOs. Accounting for this reduction in the number of new issues and the increase in the amounts raised, one observer com­mented, "the average size of each 1983 deal was a quarter of the $70 million average for the deals done."22 In other, more difficult financial environments, most dramatically, following the stock market crash on October 19, 1987, the new-issues market became very quiet for entre­preneurial companies, especially compared to the hot market of 1986. As a result, exit opportunities were limited. In addition, it was very dif­ficult to raise money for early-growth or even more mature companies from the public market.

The more mature a company is when it makes a public offering, the better its terms will be. A higher valuation can be placed on the com­pany, and less equity will be given up by the founders for the required capital.

An entrepreneurial company might choose to go public to realize some of the following advantages:

To raise more capital with less dilution than occurs with private placements or venture capital

To improve the balance sheet and/or to reduce or to eliminate debt, thereby enhancing the company's net worth

To obtain cash for pursuing opportunities that would otherwise be unaffordable

Exhibit 5.9 Initial Public Offerings (1980-2003)

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To access other suppliers of capital and to increase bargaining power, as the company pursues additional capital when it needs it least

To improve credibility with customers, vendors, key people, and prospects

To give the impression of "playing in the big leagues"

To achieve liquidity for owners and investors

To create options to acquire other companies with a tax-free exchange of stock, rather than having to use cash

To create equity incentives for new and existing employees

Notwithstanding the above, IPOs can be disadvantageous for a num­ber of reasons:

The legal, accounting, and administrative costs of raising money via a public offering are more disadvantageous than other ways of raising money.

A large amount of management effort, time, and expense are required to comply with SEC regulations and reporting

requirements and to maintain the status of a public company. This diversion from the tasks of running the company can adversely affect its performance and growth.

Management can become more interested in maintaining the price of the company's stock and computing capital gains than in running the company. Short-term activities to maintain or increase a current year's earnings can take precedence over longer-term programs to build the company and increase its earnings.

The liquidity of a company's stock achieved through a public offering may be more apparent than real. Without a sufficient number of shares outstanding and a strong "market maker," there may be no real market for the stock and, thus, no liquidity.

The investment banking firms willing to take a new or unseasoned company public may not be the ones with whom the company would like to do business and establish a long-term relationship.

Private Placement After Going Public23

Sometimes a company goes public and then, for any number of reasons that add up to bad luck, the high expectations that attracted lots of investors in the first place turn sour. Your financial picture worsens; there is a cash crisis; subsequently the price of your stock goes down in the public marketplace. You find that you need new funds to work your way out of difficulties, but now public investors are disillusioned and not likely to cooperate if you bring out a new issue.

Still, other investors are sophisticated enough to see beyond today's problems; they know the company's fundamentals are sound. Although the public has turned its back on you, these investors may well be recep­tive if you offer a private placement to tide you over. In such circum­stances, you may use a wide variety of securities—common stock, convertible preferred stock, or convertible debentures. There are also several types of exempt offerings. They are usually described by refer­ence to the securities regulation that applies to them.

Regulation D is the result of the first cooperative effort by the SEC and the state securities associations to develop a uniform exemption from registration for small issuers. A significant number of states allow for qualification under state law in coordination with the qualification under Regulation D. Heavily regulated states, such as California, are notable exceptions. However, even in California, the applicable exemp­tion is fairly consistent with the Regulation D concept.

Although Regulation D outlines procedures for exempt offerings, there is a requirement to file certain information (Form D) with the SEC. Form D is a relatively short form that asks for certain general information about the issuer and the securities, as well as some specific data about the expenses of the offering and the intended use of the proceeds.

Regulation D provides exemptions from registration when securities are being sold in certain circumstances. The various circumstances are commonly referred to by the applicable Regulation D rule number. The rules and their application are as follows:

Rule 504. Issuers that are not subject to the reporting obligations of the Securities Exchange Act of 1934 (nonpublic companies) and that are not investment companies may sell up to $ 1 million worth of securities over a twelve-month period to an unlimited number of investors.

Rule 5 05. Issuers that are not investment companies may sell up to $5 million worth of securities over a twelve-month period to no more than thirty-five nonaccredked purchasers, and to an unlimited number of accredited investors. Such issuers may be eligible for this exemption even though they are public companies (subject to the reporting requirements of the 1934 act).

Rule 506. Issuers may sell an unlimited number of securities to no more than thirty-five unaccredited but sophisticated purchasers, and to an unlimited number of accredited purchasers. Public companies may be eligible for this exemption.

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