The company completes development, launches the product, and receives very good market acceptance. However, the cost of rapid growth starves cash flow—a common problem with emerging companies—and the company goes back to the private placement market for a mezzanine round of funding.
One of the skills in navigating a company from start up to success is to reach a position in which the revenues exceed the total of the expenses, cost of future development, and required profits. Until that point is reached, the expenses must be covered by investment. Our fictitious company has consumed all its investment money completing product development and launching the product. Now there are insufficient revenues to “cover expenses.” This is a paradox because they are growing rapidly, have plenty of orders, and yet will not be able to pay their expenses without further investment. The root cause of the problem is that the cost of increased marketing, expanded sales channels, and additional operations is more than the growing revenue can support. Eschewing other alternatives, the board decides their best option is to go back to the private market for another round of investment—a mezzanine round. They anticipate that this final investment will give enough momentum to make the company self-sufficient and position it for an IPO.
The mezzanine round is completed raising $9 million at $9 a share. Notice that if we price all outstanding shares at $9, then the value of the company is approximately $156 million. With sales at $50 million per annum, this gives a ratio of value to revenue of approximately 3:1.
Table 6 - Funding For Mezzanine Round
The applications for the product are far wider than first anticipated and the company grows more rapidly than expected, but this brings new concerns. The company must now defend its position and attempt to stop any competitors from developing a “beachhead” into the market. To fund future investment opportunities, the company decides to seek a further capital infusion through public investment. With this action the founders will complete one of the “outcomes” they envisioned when the company was started.
