Mezzanine is a hybrid instrument and refers to financing that sits between equity and debt (hence the name), and combines aspects of both types. It is popular with some investors because it shields investors from certain risk associated with pure equity investment, while still providing upside if a business becomes highly successful.
There are various types of mezzanine financing, including subordinated debt, convertible notes, and equity kickers. These are often combined into a single financing facility; the degree to which an investor is willing to be exposed to risk will dictate the amount of equity upside versus debt for which he or she will negotiate.
Convertible notes (also known as convertible debt) are quite popular in Kenya, especially for early-stage start-ups. There are several reasons why investors and entrepreneurs may want to issue convertible notes instead of debt or equity. For the investors, it provides a level of protection in case the money is used in a fraudulent way – they have the right to pursue the debt issued (typically this is at 0% rate, so they will attempt to recoup their investment). For entrepreneurs, who expect their company’s equity to be worth more in the future, issuing a convertible note likely minimizes their share dilution. Both investors and entrepreneurs are also likely to benefit from kicking the can on valuation to a later point, when an institutional investor comes in. While convertible notes can be difficult to understand, the key thing to keep in mind is that the amount an investor puts in as debt will be converted to equity at a later point, to be defined in the contract. The share price will determine how many shares that funding injection will be converted to.
To give a very brief example: a founder and an investor agree to a $50k convertible debt, at a discount of 20%. This means that when the company raises money in the next round, the early investor is able to purchase shares at 80% of what they are worth. If, for instance, the shares are priced at $1 each in the next round, the investor will be able to purchase them for $0.80. That means instead of buying 50,000 at $1 each for the $50k lent in the convertible note, the early investor will actually be able to purchase 62,500 shares ($50k/$0.80).
There are other considerations and clauses that can be agreed upon, including a valuation cap. An in-depth overview of convertible notes is outside the scope of this guide, but there are plenty of online resources, books, and individuals who will be able to walk entrepreneurs through the complexities.
Mitigates risk for investors, meaning better funding terms than straight equity
Can delay valuation of start-up which is imprecise in early stage companies
Entrepreneurs may need to make regular payments to funders
Can be overly complex and expensive to arrange