How Does Mezzanine Financing Work for Smaller Businesses?

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If you don't have any collateral to help secure a business loan, you may feel like your startup dreams have hit a dead end. Don't give up just yet! Mezzanine financing for smaller businesses could allow you to get the loan you need without collateral.

In fact, mezzanine financing turns your business into a type of collateral. When working with mezzanine lenders, you sign a contract that states that the lender will receive an equity stake in the company if you end up defaulting on your loan. In other words, the lender will own a share of your company equal to the remaining balance owed on your loan. The lender can then sell that share as a public offering in order to recollect the debt.

Advantages and Disadvantages of Mezzanine Financing

New small-business owners may have a difficult time getting approved for traditional bank loans or bank financing if they have poor credit, have a weak business plan, cannot produce the company's balance sheet or lack any kind of track record. In comparison, mezzanine funds are much easier to receive because these particular small-business investment companies do not perform thorough due diligence. In other words, mezzanine lenders do not have a rigorous approval process.

The virtually open-access application process gives many people an opportunity to meet their financing needs, but it also leads to the major disadvantage for this type of financing: a high interest rate, often between 12% and 30%. Charging a high interest rate helps mezzanine lenders mitigate the risk they take by funding businesses that have a high probability of failing in the first year.

A high interest rate also helps combat the fact that mezzanine debt is considered junior debt, not senior debt. That means other debt that the business owner possesses, such as low-interest loans from banks or other senior lenders, will take precedence and must be repaid before mezzanine loans if the business fails. Because the mezzanine lender may not see the money right away, a high interest rate is charged to make up the difference in the meantime. Mezzanine lenders are therefore less like a traditional financial institution and more like a private equity holder.

Is Your Business a Candidate?

Your business may be a candidate for a mezzanine loan, but because of the high interest rate associated with this type of financing, it's wise to investigate low-interest options first. For example, if you can tap into any private equity, such as home equity, you may be able to get a loan for a lower interest rate than if you pursued a mezzanine loan.

Depending on your credit score, the strength of your business plan, whether or not you have a co-signer and any personal or business collateral you may own, you may be a good candidate for a traditional bank loan. Other options include business credit cards or an equipment loan, in which the business equipment purchased with the loaned funds becomes collateral for the loan.

A mezzanine loan is an option to consider if you've exhausted your other resources and still need additional funds. It's low on the list of recommended financing routes simply because of the high interest rate. Plus, you'll need to consider the fact that the mezzanine lender will have voting rights if you default on your loan, and the lender ends up owning a share of the company. This could affect how you run your business in the future.

Finding Mezzanine Financing for Small Businesses

If you're ready to explore the options for mezzanine financing for small businesses, start by searching for reputable venture-capital companies that offer mezzanine loans. These financial groups make money by investing in other businesses, and mezzanine financing is just one of the options made available to business owners like you. Be sure to find an interest rate and loan terms with which you're comfortable before signing any paperwork.