Mezzanine financing gets its name because it sits in the middle of normal loans and equity finance. It can be an attractive way for growing businesses to bridge the gap between what banks will lend against assets and the value of a large project or acquisition. Major sources of mezzanine financing include banks, pension funds, insurance companies and private investors.
Mezzanine financing is a type of loan that uses the company's shares as collateral. If you can't pay the loan, the lender converts the debt into an equity share of your company.
Debt and Equity Explained
To understand mezzanine finance, you first must understand the other two broad categories of business funding: debt finance and equity. Debt is the preferred structure for most business loans – the lender gives you money in return for fixed repayments plus interest over a set timeframe such as 10 or 15 years. The lender knows exactly what return she will get from her investment. Equity finance involves selling shares in your business to shareholders. Investors get a stake in the company ownership and share your success by the share value going up. It is riskier than debt finance, but the rewards are potentially greater.
Mezzanine Sits in the Middle
Mezzanine finance sits in the middle of debt and equity finance and combines elements of both. The mechanics vary between lenders, but typically you will get a loan using shares in the company as collateral. If you cannot pay the loan back after a specific period, the lender converts the debt into an equity share of your company at a predetermined price per share. The lender can recover its costs through shares in your business that potentially will increase in value.
Mezzanine Finance for Business
For businesses, mezzanine finance has many attractive features. It is an unsecured loan, which means you are not putting down an asset as collateral, and lenders tend to do minimal due diligence. Mezzanine finance takes a junior position in your company's capital structure, which means you only repay the loan once senior obligations are met should the company go out of business. These features result in high interest rates. Most lenders will look for returns in the region of 12 to 20 percent.
When to Use Mezzanine Finance
Businesses typically use mezzanine financing to raise "top up" cash for big projects. Say you want to raise $15 million for a management buyout and you have agreed to a loan for $10 million with a standard lender. A mezzanine agreement might give you another $3 million. You only need to put in $2 million instead of $5 million. Mezzanine finance is based on your ability to pay the debt from cash flow. To qualify, you need a history of solid earnings and growth, high cash flow and an established reputation within your industry.