In its purest form, Mezzanine Debt is a business debt instrument that carries along with it certain rights to convert debt into equity (stock, common shares, partnership interests, LLC membership units, etc.). Mezzanine debt financing is not a pure debt or a pure equity instrument. It is something in the middle. In fact, the word ‘mezzanine’ is derived from the Italian word ‘mezzano’, meaning middle, and is used to describe how this particular form of business capital combines elements of both debt and equity financing into one instrument. It is used typically when a business is in a high growth environment and needs more capital than it may borrow from a traditional lender.
What Type of Business Should Use Mezzanine Debt Financing?
Mezzanine debt financing is designed for companies who are already cash flow positive, typically established businesses which require capital for growth opportunities. Mezzanine financing is risky for lenders, so they depend on a company’s demonstrated ability to create positive cash flow. This form of business capital is not appropriate for startups or newly- formed businesses.
When is Mezzanine Debt Financing Used?
In addition to a business requiring capital for expansion activities, mezzanine debt financing is often used in instances of ownership transition. If a business owner wants to exit his business by selling his stock to management or other shareholders, the company can borrow a combination of senior debt and mezzanine capital to finance the transaction. Business owners can also use mezzanine financing to create liquidity, using it to fund a dividend and allowing the owner to invest in other areas.
What Does Mezzanine Debt Cost?
Mezzanine financing is more expensive than other forms of capital because it is unsecured and subordinated, falling behind senior debt and secured junior debt. Mezzanine lenders typically look for an internal rate of return (IRR) of 15%-25%. These rates can come from a combination of cash interest, payable in kind (PIK) interest, and equity. Businesses should also expect to pay an arrangement fee due at the time of closing.
Why Would a Business Owner Use Mezzanine Debt?
This type of financing offers several benefits to the business owner who expects to grow quickly and will have no problem paying off an expensive loan. First, mezzanine financing is flexible in its terms, coupon structure, and amortization schedule. The backing of a mezzanine lender can also increase the amount of capital a traditional bank is willing to finance, thereby reducing the amount of equity needed for the transaction. The addition of mezzanine financing may allow a business to grow sales, increase inventory, increase employees, or increase research and development while reducing the need for the current owners to dilute their equity stake.