A Simple Guide to Mezzanine Financing:

Mezzanine financing is a fancy term for a type of funding that sits between Debt and Equity. To understand it, think of it as the middle layer in a sandwich. It combines elements of both Debt and Equity. With mezzanine financing, a business can raise money for growth without giving up too much Equity ownership.

Mezzanine funding is often used when a business is looking to expand but doesn’t want to go through the hassle of a traditional bank loan or give up too much valuable equity and control in the business.

How Does Mezzanine Financing Work?

Let’s break it down. Imagine you own a pizza shop. You want to open a second location but don’t have enough cash. Rather than taking out a bank loan, which requires monthly payments, you might look for an investor willing to provide mezzanine financing. In exchange for their investment, they’ll want a piece of the pie — usually in the form of interest payments and some equity in your business. However, because the investor is receiving debt payments which reduces its risk, if there is an equity component to the mezzanine financing, it includes less equity than a traditional equity investment in the business.

Mezzanine financing may also include a convertible debt feature. That is, if the business is unable to repay the loan, the investor can convert their debt into Equity ownership in the business. This is a much better option than a traditional lender foreclosing on the business assets to receive its loan repayment.

Mezzanine funding typically has higher interest rates than traditional loans. However, it also comes with more flexibility. Lenders or investors might not require regular payments right away, giving you the breathing room to establish your new location. Once your second shop is up and running, you can start paying back that investment.

Revenue-Based Financing

In some mezzanine financing deals, the investor may add more flexibility to the repayments by tying the repayments to Revenues. That is, the business repays the loan as a percentage of Revenues instead. As such, the business pays back the loan in proportion to its ability to repay it based on the amount of revenue it actually produces.

This is called Revenue-Based Financing. The investor receives a percentage of Revenues called a Royalty payment. A royalty is not a loan with a fixed payment. And a royalty is not an ownership stake in the business. It is mezzanine financing so it sits somewhere in between these two types of financing.

What Types of Businesses Use Mezzanine Financing?

Many businesses tap into mezzanine financing, especially those in real estate and private equity. For example, a construction company looking to build a new office complex might seek mezzanine financing to cover the gap between what it can obtain a traditional loan and the total project cost. In this case, mezzanine financing is used as a bridge loan.

Even startups can find value in this kind of funding. When a new tech company launches an exciting product, they might need cash to ramp up production. Instead of loading up on debt that their new unpredictable financials may not be able to repay, or selling too much equity and control to investors, mezzanine financing can give them a chance to grow while keeping control of their business.

Benefits of Mezzanine Financing

1. Flexible Payments

One key benefit is flexibility. With traditional loans, the business will generally need to make regular payments, whether or not the business is making money. With mezzanine financing, investors often allow the business to skip payments until after it has turned a profit. Or investors may take repayment as a percentage of actual Gross Revenues produced.

2. Less Ownership Dilution

The business shareholders won’t lose too much ownership of your business. This is crucial for entrepreneurs that want to keep their vision intact. By opting for mezzanine financing, the entrepreneur can retain more control while still accessing necessary funds.

3. Increased Cash Flow

The cash the business receives can be reinvested into your business, leading to more growth and opportunities.

4. Speed

Compared to traditional loans, mezzanine financing can be secured rather quickly. This means the business receives the funds it needs, right when it needs these funds.

Risks of Mezzanine Financing

1. High Interest Rates

The interest rates are generally higher than rates for traditional loans.

2. Convertible Debt to Equity Structure

If the business struggles and is unable to repay the loan, depending on the financing agreement, the investor may be able to convert debt to equity and receive ownership and some control in the business. This is better than losing the business to a lender but the shareholders receive an additional business partner that they may not want.

Is Mezzanine Financing Right For Your Business?

Mezzanine financing can be a powerful tool for businesses that want to grow without sacrificing control. It acts as a bridge, helping you get from point A to point B in your business journey. It’s important to analyze the business and its financials carefully to assess whether it can afford the mezzanine financing terms.