Another point to consider is whether and to what extent you want to have investors participate in potential losses of the company. This is possible or even required in some financing instruments and impossible in others.

In equity finance when investors hold ownership stakes, such as shares in the company, they are directly exposed to the company's financial performance. This means that equity investors directly participate in the company's losses, which can result in a decrease or even complete diminishment in the value of their shares. In extreme cases, shareholders may lose their entire investment. Equity investors are last in line to receive any remaining assets during liquidation after all debts and other obligations are settled. Even while the company is operational, equity investors typically must wait until accumulated losses are cleared before they can receive any returns.

In debt-based financing (including most mezzanine investments), investors provide capital to the company without acquiring ownership stakes. Depending on the exact financing instrument used and its structure, they can include no participation in the company's operational losses but can also be structured to allow for some level of loss participation, effectively bridging the gap between traditional debt and equity structures. If the company encounters severe financial distress and cannot meet its debt obligations, debt holders may incur losses through reduced interest payments, delayed repayments, or debt restructuring. Despite these risks, investors using debt-based instruments with loss participation typically have a higher priority than equity investors during liquidation, meaning they are paid before equity holders but after secured creditors when the company's assets are liquidated. Further, with mezzanine financing, payouts can begin as soon as there is positive cash flow, even if past losses haven’t been fully covered. 

When making investment decisions, the costs associated with a transaction, including potential changes to terms or taking on new investors later on, are often crucial factors to consider. These costs can add up significantly, particularly when notarial services, tax advisers, or legal fees are required with each change of investor. This is especially relevant if you plan to involve a large number of investors or expect frequent changes, as more complex structures and instruments often require additional expertise from tax advisers and lawyers.

Debt capital or contract-based financing instruments generally require less effort to structure, and are easily changeable. Unlike equity investments, they typically don’t require notarial services, though they may still incur ongoing administrative costs, e.g. in the case of profit participation rights.

The classification of financing instruments on the balance sheet as debt or equity can sometimes be uncertain and complex, especially when dealing with mezzanine capital. This complexity arises because classification can be viewed from multiple perspectives – economic, accounting, or tax-based, static, or dynamic – each of which may interpret the instrument differently. Adding to this complexity, different institutions, such as banks and funding agencies, may also apply their own criteria and internal policies to classify instruments, which can sometimes vary significantly. For example, not all banks consider subordinated loans as economical equity. This can lead to perceived “overindebtedness”, eventually limiting certain financing options. Similarly, state funding programmes often adhere strictly to their guidelines and may only recognize traditional equity instruments. 

But don't worry – this doesn’t mean mezzanine capital exists in a state of total uncertainty. In Germany (and we assume in other countries as well), most classification issues can generally be clarified with the support of tax advisers and legal experts, who can help navigate these nuances. However, it’s true that mezzanine instruments might introduce additional complexity in certain situations. Therefore, if access to early-stage bank loans or specific grants is crucial, it may be prudent to first confirm the institution’s requirements or consider opting for traditional equity or debt to minimize potential obstacles.

Ultimately, whether a chosen instrument is classified on the balance sheet as equity or debt capital depends on its specific legal structure, the jurisdiction you are based in and the criteria used by financial institutions. Therefore, it's crucial to have detailed discussions with your financial advisers to ensure alignment with your strategic goals and compliance with financial regulations.

Another crucial aspect to consider is how different types of investors – such as banks, funding agencies, and institutional investors – will respond to the financial instruments you choose. Different investors operate under varying regulations, and these regulations often dictate the kinds of financing instruments they can engage with. For instance, some investors are unable to participate in debt or debt-like mezzanine financing due to strict regulatory oversight. And even beyond regulations, there can be structural constraints, too. For example, agreements like LP (Limited Partnership) contracts aren’t regulatory, but set the terms between investors and the fund and define the types of investments the fund will pursue, such as high-growth, high-risk equity (like “unicorns”) or more conservative debt or mezzanine investments. Once these LP agreements are in place, changing them is very complex and requires a lot of work, to the point of being almost impossible. This means that LP contracts can strongly influence what kinds of investments a fund can or is willing to make, limiting flexibility even when opportunities arise.

If you’d like to dive deeper into why certain investors can or prefer to invest in specific types of businesses (e.g., unicorns vs. zebras; equity vs. debt or mezzanine), we recommend checking out this article:

Another point that you will need to work through with your lawyer and tax consultant as well as the tax consultants of your investors is the tax implication of your chosen financing instrument and structure for yourself and your investors. You don’t want to build an awesome structure and then learn that this would lead to unnecessarily high and early tax payment on one or both sides. Particularly relevant is to check (1) how capital costs will be treated in your company, (2) how closing the contract will affect taxes of your investor, (3) how redemption payments will affect your investor’s tax liability, and (4) how potential conversions into other instruments are treated.

The tax treatment of your financing instrument depends on several factors: the structure of the instrument, the countries and jurisdictions involved, and whether the investor is a private individual or an investment company. Certain instruments can even add another layer of complexity. For example, in some financing structures, investors have to pay taxes on interest or dividends long before they receive any actual payments (dry-income issue). Even if this issue is initially avoided, converting the instrument (and any accrued interest) into equity later on could create new tax implications. Therefore, consulting with tax professionals on different scenarios can help prevent unexpected issues.