A Tutorial on Mezzanine Finance for Entrepreneurs

Many business owners and entrepreneurs are familiar with term loans, SBA funding, and other sources of capital, but when I discuss mezzanine funding with them, most of them tend to start staring straight through me as if I’m speaking in ancient Persian.

This is a quick article that explains:

• What mezzanine finance is
• Pros and cons of mezzanine finance
• How it can be used to help finance your business

What is Mezzanine Capital?

Mezzanine capital is a form of financing that is typically extended by Mezzanine Lenders to private businesses looking for funding as part of a growth strategy or leveraged buyout transaction.  Every form of financial capital has a certain “seniority” in the capital structure.  While this can get complicated, the simple way to think about it is as follows:

• debt capital (a bank loan for example)
• mezzanine capital or unsecured debt
• equity capital

If an entrepreneur is looking to raise $20M but the traditional debt markets will only enable the company to raise $10M of debt, mezzanine capital can, where appropriate, fund the gap.

Pros

• Mezzanine capital does not dilute your equity ownership
• Mezzanine capital does not usually require monthly or quarterly interest payments; it’s usually paid at maturity which allows you to take all current cash flow and pour it directly into growing your business

Cons

• Mezzanine capital is more expensive in terms of the interest costs
• Mezzanine lenders will loan to your firm only at rates several percentage points higher than a term loan, and they will also usually attach warrants so that they participate in your company’s success

When is Mezzanine Finance usually used?

• Mezzanine capital is often used when a company with little physical asset base is growing quickly and cash flows are improving but the firm needs some liquidity to grow more effectively (finance inventory, headcount, new territory buildout) without diluting the equity holders
• To stop-gap the difference between equity investors and traditional lenders.  This often occurs as part of an LBO transaction (leveraged buyout) in which an equity investor wants to contribute a certain amount of equity capital, a lender commits to a certain amount of debt capital, and there is a gap that is filled by Mezzanine capital which blends the risks of debtors and equity investors to form a 3rd layer in the capital structure.