The terms Venture Capital, Angel Investors and Mezzanine Financing are often tossed around in business
…what the heck are they and do you really NEED to know what they mean?
Basically, they are all terms used when talking about various methods of securing investor financing in business and each has its place in certain types of business transactions.
Most of us financed our businesses in the traditional way: We went to a local bank where we felt comfortable and had an established relationship, and they offered us a loan with acceptable terms and conditions. We pledged the assets of the business as well as personal assets, like our home or investment portfolio, as collateral to secure the loan.
That’s the traditional world of corporate finance – the one with which we are most familiar.
There is another financial world, however, where entrepreneurs, business start-ups, and those with a great idea but limited capital go for financing.
Venture Capitalists and Angel Investors are two groups who provide financing in these situations.
Start-up ventures looking for financing to realize their concept or get their business off the ground will sometimes exchange an ownership stake in the business for capital.
Because new concepts and ventures carry more risk, investors usually require more significant ownership interest and the return on investment they seek (the “interest” they expect in traditional banking terminology), reflects the level of risk associated with the investment.
Venture Capitalists or Angel Investors
Typically these investors only want to be involved with a business in the early stages, the stages of accelerated growth. Once the business is able to sustain itself, many Venture Capitalists and Angel Investors expect the return on their investment to reflect the increased value of the company. It’s not uncommon for them to receive 10x, 20x or 30x their initial investment over five years.
Another investor financing option, Mezzanine Financing, refers to situations in which a combination of debt and equity are used to finance the expansion of an existing business. In some cases, the funds needed to finance an expansion – whether to add product lines, make acquisitions, or afford other growth opportunities – may not be available through traditional financing because of limited ownership equity.
Mezzanine Financing refers to an agreement in which a lender agrees to provide the needed capital in exchange for the right to convert to an ownership or substantial equity interest in the company IF the loan is not paid back on time and in full. A Mezzanine Lender’s debt is subordinated to any debt provided by senior lenders such as banks and venture capital companies.
Mezzanine Financing can involve a minimum of due diligence on the part of the lender and little or no collateral on the part of the borrower. As a result, this type of financing is more expensive with the lender seeking a return in the 20-30% range. The cost of capital becomes a major component of the transaction reflecting the level of risk associated.
Venture Capital and Angel Investing are viable financing methods most often used for:
- the commercialization of patents,
- new inventions,
- medical devices and drugs,
- start-up businesses with a well-researched, well-marketed business plan
…that attract interest from investors seeking high rates of return.
Mezzanine Financing serves a necessary function as well, bridging the the short fall of owner assets needed to secure financing from traditional sources.
Each of these investment methods comes at a much greater cost due to the risks associated.