Foundations of New Venture Finance 261
is between the cheap balcony seats and the more expensive but desirable orchestra seats),
is the bridge between the venture as a private firm and the prospect of a public offering.
Mezzanine financing enables successful privately held companies to obtain financing
without going public, letting the owners keep control. Mezzanine financing is a blend
of traditional debt financing and equity financing, with some benefits of both. It has the
no-collateral benefit of equity and the control benefit of debt. But in order to make it
profitable for the lender, interest rates are frequently much higher than market, in the
20-30 percent range. Lenders also have the right to convert the debt to equity if there
is a default.^9
Most new ventures remain small, never going beyond first- and second-stage financ-
ing, and almost none will qualify for venture capital funds. Yet at the initiation of a ven-
ture, at its creation, all is still possible even if the odds are long.
Street Story 7.1 offers additional practical advice on cash management. It may be
more an art than a science and it requires attention and creativity.
SOURCES OF FINANCING
The initial financial objective of the entrepreneur is to obtain start-up capital at the low-
est possible cost. Cost is measured in two ways. One is the return that will have to be
paid to the investor. The other is the transaction costs involved in securing, monitoring,
and accounting for the investment. An investor may be satisfied with what appears to
be a below-market return on investment, but if the cost of the transaction is significant-
ly high, the entrepreneur may wish to consider an alternative source of financing. The
long-term sources of cash for the venture are debt and equity. In most cases, equity
financing is more expensive than debt financing: Pure debt has a fixed return over a peri-
od of time, but the potential gains for investors in equity financing are unlimited. Figure
7.3 illustrates how these two sources combine to build the liquidity level of the firm.
The types and sources of financing available to the new venture depend primarily on
four factors:
- The stage of business development: The more developed the business, the higher
the chances and the better the terms for outside financing.
- The type of business and its potential for growth and profitability: High-potential
firms can attract financing at better terms.
- The type of asset being financed: The more stable the market for the asset, the eas-
ier it is to sell and to recover costs for the lender in case of default.
- The specific condition of the financial environment within the economy: When the
economy is good, lenders and investors are looking to put their cash to work at a
profit. When the economy is poor, investors are conservative and reluctant to
invest.
The elements of the overall financial environment that should be considered are:
- Interest rates and their term structure: Under the normal rate structure, short-term
rates are lower than long-term rates, so the borrower generally prefers a series of
short-term loans. When this is reversed, the borrower prefers a long-term, fixed-rate
