Inventors often have brilliant ideas, often excellent patents. Yet bringing them to market may be a tremendous challenge. Finding investors for going concerns is hard enough; finding investors for new, greenfield projects is even harder. This article will first deal with some of the reasons why finding investors is such a challenge for inventors; and second, I will talk about what investors look for and what an inventor can do to maximize the probability of finding investors.
Why is finding investors for inventions such a challenge?
In a nutshell, it boils down to lack of track record. There is many a slip between cup and lip, between idea and execution, to the point of an invention commercialized to successfully delivering cash flow and value for investors. Hence, risk is significantly higher than for a going concern, where a company has already gone through its teething issues, and usually already established cash flow. It therefore takes a certain breed of investor who has the kind of appetite for risk, and the expertise to evaluate investment proposals. There are relatively few of these in Central Europe, particularly who are prepared to offer equity financing for larger amounts.
Where inventors come up with a brilliant inventions or technologies, and then seek to commercialize it, they run into numerous challenges:
- If the invention is not patented, the act of showing their concept to potential investors increases the chances that someone will run away with the idea.
- More often than not, inventors are looking to raise financing on a shoestring budget. They lack the funds necessary to obtain patent protection, advisory fees, market research, etc. You usually get what you pay for.
- The inventor often does not have the expertise to commercialize the project; often they will seek to maintain control of the venture. From the perspective of an investor, it is a non-starter to have a project managed and controlled by someone with only technical expertise, lacking commercial expertise, or indeed the experience and track record of launching a comparable project.
- There may be a significant valuation gap between what the inventor expects for his world-changing invention, and what an investor is prepared to pay. For example, I once met a physician who had a truly remarkable invention that was likely to dramatically alter the fight against cancer. But he was expecting to raise over $200 million, while keeping control, and lacking any real business experience. A non-starter.
What investors look for and what a project promoter can do to maximize the probability of finding investors
- Generally to finance an invention, there must be a powerful idea. A ho-hum idea, or even a strong idea, might be insufficient. The idea must be outstanding. And preferably, it should be an idea that has certain barriers to entry (e.g. patent protection).
- While it is probably not possible to cure the lack of track record with respect to bringing a particular technology or project to market, it is possible to put forward a project team that has depth of relevant experience. This will add credibility, hence reduce perceived risk for investors.
- It is important to provide as much visibility as possible on the revenue side: is it possible to receive orders? A strongly worded letter of intent? Or detailed market research that will forecast demand in a way that will be credible for investors? The better you can do, the better the chances of financing.
- You must also get a grip on the cost side of the equation, and capital expenditures. A project with a low “burn rate”, everything else being equal, will be preferred to a project that is “gold plated”.
- The investor will want to see professionally prepared projections that give an appropriate risk-adjusted rate of return.
There are thousands of worthy technologies and inventions throughout Central Europe that are not achieving funding due to the factors mentioned above. This is a loss not only for inventors, but for society at large.
Mezzanine financing may be used both as a way of raising expansion capital for an enterprise or for financing the acquisition of an enterprise. As the name implies, in the financial mix of a firm, mezzanine financing is located between the “ground floor” of equity and the “first floor” of debt (e.g. mezzanine finance is a hybrid instrument containing features of both debt and equity). In this article we will take a look at the option of mezzanine financing as a source of capital.
What is mezzanine financing?
There is no single formula for this hybrid instrument: it could be preferred equity with a guaranteed level of dividend, convertible to straight equity at the option of the preferred equity holder, or some form of debt, also convertible into straight or preferred equity. The conversion option gives the owner of the mezzanine instrument a higher degree of security than if he were a straight equity holder (e.g. higher priority in the event of the liquidation of the firm and priority in payment of dividends or interest compared to straight equity holders), while allowing the investor access to the benefits that an equity holder has (e.g. conversion of debt or preferred shares into straight equity prior to a liquidity event). A mezzanine holder will typically rank subsequent to secured or even to unsecured debt holders, often holding the shares of the common shareholders as security.
A mezzanine financier will typically negotiate various put or call options in order to help ensure the liquidity of his holding, help acquire control in case the company dramatically underperforms and help ensure an eventual exit.
What kind of returns are typical for mezzanine financing in Central Europe today?
Given that the degree of risk for a mezzanine holder is lower than for the owner of plain equity, yet higher than for a holder of plain debt, it stands to reason that the rate of return is usually also somewhere between that of straight debt and equity. For example, if holders of straight equity in a particular venture would expect returns of 25% or more and holders of debt would expect 6-12%, then a holder of a mezzanine interest might expect a return in the range of 15-20%. The precise yield would obviously depend on the debt/equity mix and the degree of risk absorbed by the mezzanine holder (e.g. whether the preferred dividends, if any, are 5% or 10% of the value of the mezzanine instrument, the precise nature of the put or call options, the strike price at which the instrument might be convertible into straight equity and the overall leverage level).
Why is mezzanine financing so much more expensive than straight debt?
Mezzanine lenders typically do not have a registered security interest in the assets of a company. This means that, in the event of default, repayment of the mezzanine may commence only after all senior obligations have been satisfied.
Another factor, and one of the difficulties faced by companies issuing mezzanine instruments, is the financial sophistication required in pricing the value of the embedded put or call options, or other aspects of the mezzanine financing, where the provider of mezzanine financing is typically much better equipped than the company making use of such financing.
When should the owner of a business consider mezzanine financing?
Mezzanine financing allows business owners to obtain financing or growth capital that permits higher leverage (e.g. an additional level of financing to straight debt), without burdening the company with extremely high debt service obligations (e.g. mezzanine holders may be paid by preferred dividends, payable only when the company is profitable). Such high leverage financing will either not require collateral against the company’s assets or, if it does, the collateral will be subordinated to more senior debt holders.
Mezzanine financing may require less cash payment of interest or dividend than junk bond financing, as the mezzanine financier may rely on his equity conversion option to boost his overall return, thus conserving cash flow for the company.
Mezzanine financing might be more appropriate than straight debt where there is a considerable degree of volatility in expected cash flows (cheaper debt might be available for a company where lenders foresee steadily increasing cash flows).
When should the buyer of a business consider mezzanine financing?
Private equity funds, management buyouts and other types of acquisitions that like to use leverage are frequent users of mezzanine financing. Mezzanine financiers are typically comfortable piggy backing on the due diligence of a private equity purchaser on a business and allowing the private equity firm to take the driver’s seat in managing the acquired company, at least while the business plan is being met.
In conclusion, mezzanine financing is not for everyone. It requires considerable financial sophistication in order to correctly price returns. However, for the financially sophisticated, it opens up a new source of financing and is a creative way of allocating risks and returns between the different stakeholders of a company.
