Finding mezzanine equity financing isn't easy. A mezzanine deal is risky for the lender, so the rate of return on a mezzanine loan is high. However, the terms are often negotiable, and if your company does well, mezzanine lenders usually won't interfere with your management decisions.
Mezzanine loans are called mezzanine equity because they often give the lender an equity stake in your company. For example, if you default on the loan, the terms may entitle the lender to convert the debt into stock shares. The mezzanine equity definition isn't a legal term and may be used to label other types of deals.
Mezzanine equity's name probably comes from the architectural mezzanine, a small middle floor found in some buildings. That's because if the company fails, the lender's right to repayment falls below other loans but it's greater than regular equity owners.
Mezzanine lending is also in the middle in having qualities of both a loan and equity. Like a loan, you make regular payments on the debt, but if you default, the lender turns the debt into mezzanine shares in your company. The terms of some mezzanine equity deals also give the lender a stake in the company over time as part of the repayment.
Mezzanine falls in the middle in a third way. Some businesses bridge the gap between the original mix of venture-capital investors and loans and the later public offering with a mezzanine loan.
In some ways, a mezzanine equity loan is a lot like any other financing deal. The mezzanine lender cuts you a check, then you make periodic payments on the loan. The differences from regular financing are significant, though.
The interest is high, often as much as 15% to 20%, sometimes more. Typically the lender gets some claim on your assets: either the loan converts to an equity stake if you default or your loan payments include an ownership share along with cash. The combination of regular interest and equity is what makes the deals attractive to mezzanine lenders.
That said, mezzanine equity loans aren't a good source of financing for startups. Even with the high rate of return, mezzanine lenders want to see you have good cash flow and an established track record of earnings and growth. However, if you're established and growing and you want, say, a mezzanine loan for real estate there's a good chance you can find funding.
Despite the high interest rate, going with mezzanine equity offers you some advantages over equity or regular debt:
- It's cheaper than giving your investors a straight equity stake.
- Companies that offer mezzanine equity deals are in it for the long haul, so there's less pressure to give them an overnight return on their investment. They may even be willing to offer you advice.
- Mezzanine lenders are flexible in working out repayment terms.
- As long as your company does well, mezzanine equity lenders are usually content to stay hands-off. Other sources of financing may not be that obliging.
It also has a downside, on top of the high interest rate.
- Mezzanine equity deals typically take several months to work out all the details.
- Mezzanine lenders often require restrictive covenants to protect themselves. A typical mezzanine financing example of such restrictions is that you can't borrow any more money, as those loans take precedence over the mezzanine deal.
Business owners usually look to mezzanine financing when they don't have enough collateral to attract conventional loans or the loan rates available are even higher. The classic mezzanine financing example is a leveraged buyout, which can be very profitable for equity investors. If everything works smoothly, the investors and the mezzanine equity lender walk away with a tidy profit.