290 6 Mezzanine
- Stages. There is a detailed outline of the various stages of financing (like seed
investment, prototype testing, early development, growth stage, and so forth).
At each stage the firm is given just enough cash to reach the next stage. - Unilateral exit. The venture capitalist reserves the right to stop funding unilate-
rally at any stage. Sometimes the venture capitalist may have a right to demand
repayment of all or some of the already invested capital. Debt instruments can
be used for this purpose. - Regular exit. The venture capitalist wants to benefit from an increase in the va-
lue of the firm. This requires ownership of shares that can be sold to other in-
vestors. - Anti-dilution. Pre-emptive rights and other anti-dilution mechanisms enable
venture capitalists to control new financing. - Preference shares and conversion rights. Preference shares will be senior to the
entrepreneurs’ ordinary shares in liquidation. The right to convert preference
shares or convertible loans to common shares enables the venture capitalist to
obtain control and fire managers if some key investment objective is not met or
to benefit from an increase in the value of the firm. Making control rights con-
tingent enhances managerial incentives and boosts borrowing capacity.^22 - Non-competition clauses. Non-competition clauses for the entrepreneur and key
managers and employees are designed to reduce commercial risk (section 16.3).
Shares. A venture capital firm invests primarily in shares because this will enable
the venture capital firm to profit from the success of the venture. The venture capi-
tal firm can mitigate commercial risk by subscribing for preference shares that en-
sure that the venture capital firm gets a priority call on the profits of the company
in the form of dividends; those preference shares may further be convertible into
common shares.
The problem of dilution. The issuing of new shares will raise the question of di-
lution. Any new claimant to the assets and/or income of the firm reduces the per-
centage interests of existing claimants. If A owns 100% of shares and B purchases
newly issued shares that will represent 25% of all shares, A’s share of claims on
the firm’s future income is diluted. On the other hand, B might contribute assets
that enable the firm to increase its future income by 50%. In that case, the income
that will actually be distributed to A may increase.
Typically, existing shareholders try to keep as much of voting rights as possi-
ble. New investors try to prevent the dilution of their holdings when the firm is-
sues new shares in the context of later financing rounds.
Most venture capital financings include anti-dilution provisions that protect fi-
nancial investors. Purchasers of shares in venture financings look for protection
against subsequent share offerings at lower prices, as well as structural protection
against changes in the corporate structure.
(^22) Tirole J, The Theory of Corporate Finance. Princeton U P, Princeton and Oxford (2006)
p 394.