Startup Finance 101: Debt, Equity, and Mezzanine Capital

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An illustration of a man balancing finances, a bag of money and cash, illustrating the juggling of startup finance options: debt, equity, and mezzanine capital.
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Economics 101 dictates that the objective of every free-market enterprise is to make money for its stakeholders. However, the old adage “You’ve got to spend money to make money,” is true for a reason. Business owners must spend money to hire employees, build a product or execute a service, acquire supplies, keep the lights on in the office, and fund the day-to-day tasks that result in the execution of the company’s stated business model.

This article series will explore the various sources of capital available to entrepreneurs scaling built environment technology companies and explain why capital structures are important to the overall success of a startup. While the most common form of capital we cover at BuiltWorlds is venture capital, venture capital is not the only form of financing a startup utilizes—nor should it be.

The first part in this series analyzed how a startup evaluates its business model to choose which capital sources it will draw on to fund the company. The process of crafting a capital structure, otherwise known as capitalization, is a delicate balance of raising enough money to get to the next fundraising checkpoint without raising too much money. Raising too much money in the form of equity can erode the founders’ equity in the business, otherwise known as dilution.

The second part in this series will delve deeper into the three main forms of capital—debt, equity and mezzanine—and provide the fundamental mechanics of each of these subjects.

Debt Capital

Debt is a contractual agreement between two or more parties, whereby one party borrows funds from another in return for periodic repayments of the principal balance. The lender also requires interest payments to cover the cost of providing capital to the borrower for an extended period of time.

Security

You will oftentimes hear of debt referred to as “secured.” Debt is the least risky form of capital from the provider’s perspective partly because the borrower will typically post its assets as collateral. This means that if the borrower fails to meet the agreed upon contractual repayment terms, the lender will be able to reclaim the assets deemed as collateral to mitigate their losses. Collateral can come in the form of physical assets (i.e., buildings, land, machinery, equipment, etc.), financial assets (i.e., cash and marketable securities, accounts receivable, inventory, etc.), and intangible assets like intellectual property.

Cash Flow vs. Asset-Backed Lending

Term loans–a traditional bank loan with a principal and interest portion of repayment–and revolving credit facilities–essentially a credit card for corporations–are “cash-flow based,” meaning repayment and security of the debt is determined by financial assets like cash, marketable securities, and accounts receivable. Marketable securities are highly liquid financial holdings that can be sold quickly and converted into cash. Treasuries are a common example. Cash-flow loans do not require physical assets as collateral because they are secured by the aforementioned financial assets. EBITDA (earnings before interest, taxes, depreciation, and amortization) is the primary financial metric of conducting repayment in cash-flow based lending. EBITDA is considered the most accurate proxy for a company’s cash flow because it excludes non-operating and non-cash expenses. EBITDA only reflects cash generated by the business’s operations.

If a borrower does not have sufficient cash flows, the loan can be “asset-backed.” In this case, the book value of physical assets, like equipment, machinery, and real estate, or other balance sheet assets, like accounts receivable and inventory, determine the amount of the loan. The amount that the company can borrow cannot exceed the value of the pieces of the business that the lender could reclaim, because the borrower is typically deemed as more risky than the recipient of a cash flow-based loan. Asset-backed, or asset-based, loans provide more flexibility to borrowers whose business models do not support a high level of EBITDA.

Senior vs. Subordinated Debt

Another reason that debt is the least risky form of capital, at least from the provider’s perspective, is its repayment preference. In a liquidation event, the lender is always repaid first. Senior debtholders (lenders of senior debt facilities like term loans, revolving credit facilities, asset-backed loans, or other senior notes) are the first to get repaid, followed by subordinated debtholder (i.e. slightly more risky debt facilities that have dent and equity components, like convertibles notes–which we will cover later) and, lastly, equity holders. A liquidation event can be a merger with another company or insolvency (i.e., the company is forced to wind down its business). The hierarchy of repayment is also known as the “capital structure.” The capital structure repays senior debtholders first because loans involve a contractual agreement whereby the borrower is legally required to repay the lender. Equity is more risky and does not stipulate that the investor must be repaid.

Benefits

Benefits of debt capital are that it comes at a specified cost, is nondilutive (i.e., the lender does not take an ownership stake in the borrower’s business), and it is short-term capital (i.e., once the principal and interest are repaid, it is removed from the balance sheet). Traditional debt is typically issued on a term, or segment of time, for anywhere between two and 10 years, depending on the facility and riskiness of the borrower. In the overall lifespan of a company, the typical term for most debt facilities–about five years–is a mere blip, which is why debt is not considered a permanent piece of a company’s capital structure.

Debt capital may be more conducive to a company that manufactures a good or product because it generates cash flow regularly (i.e., sales are typically more evenly dispersed throughout the year) and has physical assets to be held as collateral by the lender. A company selling tools recognizes revenue immediately (either upon the sale or delivery of the tool) instead of the lumpy subscription business model—more on this below.

Debt capital can also be earmarked for specific purposes, like purchasing equipment (i.e., equipment finance) or materials (i.e., trade credit). If startup decision makers can access it, debt capital can be a useful way to finance CapEx. Most commonly, this will come in the form of equipment financing and venture debt.

Drawbacks

The downsides of debt are that it can be costly, difficult to attain, and does not provide a long-term source of capital that evolves with a growing business. Interest payments can be costly depending on how risky the lender deems the borrower to be. Lenders do not want to give money to businesses that do not have the ability to repay the interest and principal, so they institute strict borrowing standards and covenants to hedge their downside risk.

Oftentimes, debt can only be used for specific purposes, imposing restrictions on the borrower as they seek to grow the business. Lenders depend on borrowers to have the capacity to make timely repayments of both the principal and interest balances. Therefore, lenders have a reputation of being scrupulous individuals and institutions, and rightfully so, as their livelihoods largely depend on the repayment ability of their borrowers. Lenders ensure this likelihood through financial and behavioral covenants, Know Your Customer (KYC) standards, and internal business reviews that all lend to frequent financial audits of the borrower. As companies grow and evolve, they may want a source of capital that can be continuously called upon without such a high degree of scrutiny and restriction.

Since debt requires repayment in the form of regular principal and interest, a company must be generating near-term cash flows to service the debt. Therefore, debt capital may not be ideal for a Software-as-a-Service (SaaS) company that requires heavy up-front costs (i.e., sales and marketing, development, and web infrastructure) and does not have physical assets to be put up for collateral in the event of liquidation. The subscription business model also generates lumpy cash flows (when the account is billed) that make regular debt repayment more unpredictable.

Equity Capital

Debt capital is a valuable source of financing for startups to avoid dilution and fund the purchase of assets, such as equipment, machinery, real estate, and more. However, it can be restrictive and expensive when it comes to growth funding; particularly, because it does not offer a long-term source of capital for businesses. A startup seeking to opportunistically pursue growth avenues may prefer a source of capital that is more flexible and able to be called upon past the typical five-year term of a loan.

Equity capital provides the issuing company with funds upfront in exchange for an ownership stake, which can be sold back to the issuing company or to another party in a secondary transaction. The issuing company is divided into shares that equity holders buy a stake in. The company’s enterprise value can be thought of as a pie, where the slices are shares of the company.

Public vs. Private Equity

Equity comes in two primary forms: public and private.

Public equity holders, also denoted as “shareholders,”-own a stake in a publicly-listed company on a stock exchange. The company’s financials are publicly available and more closely regulated by governmental institutions, like the Securities and Exchange Commission (SEC) in the U.S. Public equity makes shares of a company available to the general public, such as retail (i.e., individuals) and institutional (i.e., corporations, mutual funds, pension funds, etc.) investors.

Private equity holders, denoted as “owners,” have an ownership stake in privately listed companies. Unlike investors in public equity, private equity holders must be accredited (i.e., venture capitalists, private equity firms, family offices, endowment funds, pension funds, etc. that meet requirements set by the U.S. Securities and Exchange Commission).

Common vs. Preferred Equity

Private equity is split into two classes: common and preferred.

Common shares are generally held by founders and employees.

Preferred shares are issued to investors (i.e., VCs, angels, seed investors, strategic investors) that give the holders “preference” over common equity holders in a liquidation event. Preferred stockholders are repaid before the common stockholders.

Benefits

The benefits of equity is that there is no repayment requirement, no collateral requirement, it is a long term source of financing and it provides access to a network of experienced individuals on the company’s board of advisors. Equity does not require any form of repayment, like interest and principal on debt. Instead, issuers may choose whether or not they would like to repay investors in the form of dividends. This feature, combined with no collateral or covenants, does not place financial strain on the issuing company.

Drawbacks

The downsides of equity are that it involves giving up ownership in the company and relinquishing decision-making control. Ownership dilution is a costly tradeoff for founders to consider when choosing how to capitalize their company.

The most common form of equity for startups comes in the form of angel and venture capital. Investing in a startup is risky because the likelihood of insolvency is high—reportedly two-thirds of startups fail, according to HBR; therefore, investors expect to be appropriately compensated. Venture investors take a larger ownership stake than investors in established corporations (either public or private), making venture capital the most expensive form of fundraising.

Although venture capital comes at a high cost of ownership dilution, it is best used for funding high-growth business endeavors. When companies are incapable of generating near-term cash flows to repay debt but have high growth potential, venture capital is an optimal source of financing.

Mezzanine Capital

Mezzanine capital can be thought of as “hybrid capital,” because it bears characteristics of both debt and equity. Mezzanine financing, otherwise known as mezzanine debt, involves the receipt of funds in exchange for contractual interest payments and warrants, allowing the lender to convert debt to equity in the event of default.

Mezzanine capital is typically not used by early-stage startups, rather by growth- and later-stage companies because it is most commonly used for acquisitions, growth opportunities, and bridge financing rounds; growth avenues that early-stage companies do not have the capacity to pursue. Interest rates attached to mezzanine debt are higher than traditional bank debt—20% to 30%, according to Investopedia—because it is a more risky investment for the lender. Mezzanine debt is unsecured, meaning the borrower does not put up collateral to receive the funds like in traditional bank debt.

In the capital structure of a business, mezzanine capital is considered subordinated debt. It ranks below senior debt and ahead of equity.

It is worth discussing mezzanine capital because other financial products that we will address in the next part in this series (i.e., convertible notes and warrants) share some of the fundamental principles.

Benefits

The benefits of mezzanine capital are cost efficiency, flexibility, and potential equity retention. Mezzanine financing gives the lender the right to convert their debt to equity in the event that the borrower defaults. This results in less dilution than if the capital provider were to have taken an all-equity position.

Mezzanine financing requires only interest payments, as opposed to principal and interest, which frees up more capital for the borrower. Interest rates for mezzanine debt typically range from 12% to 20%.

Drawbacks

Mezzanine capital still comes with the risk of equity dilution. “Warrants” that allow the lender to convert their debt holding to equity come at the cost of dilution to the borrower. The high cost of capital (in the form of high interest rates) is another drawback to mezzanine capital. The equity features of this form of financing also give the capital providers significant control and influence over the company if their position converts to equity.

Further Reading

The more I write on this subject matter, the more rabbit holes start to open up. This article series is meant to be an introductory guide to the startup fundraising process, with a spin towards startups in the built environment. It is by no means a definitive guide to raising capital. Further research is recommended on the field. Below are some resources I have found helpful in my research:

The forthcoming third and final part will dissect the specific financial products that startups commonly utilize and highlight some key providers in the BuiltWorlds network.