"Mezzanine equity" is a near synonym of "mezzanine debt," in that both terms refer to a form of financing that deliberately straddles the border between debt and equity.
The more equity-like forms of this hybrid category are issued as preferred stock, but with characteristics that cause them to be treated on the balance sheet of the issuer as a liability rather than as equity.
A balance sheet is divided into three components: assets, liabilities and equity. Common stock (the form of equity that votes for directors) and much of an entity's preferred stock (non-voting equity with favorable treatment in the event of liquidation) are both on the right-hand, or equity, side of that equation.
In this context, it is important to realize the arithmetical fact that in the equation A - L = E, any constant quantity can be shifted from E to L, and the equation will remain valid.
In simple terms, 10 - 4 = 6, and if one should decide that half of the "equity" has been misclassified and should be treated as a liability instead, the equation becomes: 10 - 7 = 3: which is also valid.
The Balance Sheet
Much of the terminology of finance arises from the contemplation of bankruptcy proceedings or other wind-up. The secured creditors (often banks) are paid first in the event of bankruptcy. What is left over after the payment of secured creditors will go, next, to the unsecured creditors, including bondholders and trade creditors.
The owners of equity have the last claim on assets, a claim that arises only after all creditors are paid. Within the category of "equity," there are the subcategories preferred and common stock, with preferred stock, as the name suggests, having the prior claim.
With those definitions understood, one can also understand the hybrids. One example of an issuer of such a hybrid instrument is the company Geokinetics Inc., a geophysical services company headquartered in Houston, Texas.
Geokinetics' Preferred Shares
According to a filing with the Securities and Exchange Commission (SEC) on March 29, 2007, Geokinetics issued 228,683 shares of preferred stock on Dec. 15, 2006. It classed this as "temporary equity," and thus treated it on its books as a liability, a form of debt, because each holder of this stock was "entitled to receive cumulative dividends" at a defined rate. Until Oct. 31, 2011, those dividends can be paid in additional shares of the same series of stock. After that, though, "dividends shall be paid in cash if declared," that is, at the choice of the holder.
There were other features of the preferred stock offering by Geokinetics that contributed, along with that listed above, to the conclusion that it ought to be treated as a liability--and thus as temporary or "mezzanine" equity.
In the words of Brian W. Fields, a professional accounting fellow, office of the chief accountant of the SEC, an equity share is "generally presented [in the balance sheet] as mezzanine temporary equity if it could require cash settlement for reasons beyond the company's control."
- balance sheet image by Darko Draskovic from Fotolia.com