Mezzanine financing is a type of debt financing that sits between bank loan financing and equity financing in a company’s capital structure.  This post is meant to be a general overview of mezzanine.   I recommend that all business owners should know about this financing option because it may be useful at some point.  There are pros and cons to every financing option available, and mezzanine debt financing is no exception.  You may want to utilize mezzanine financing to make an acquisition, to buy-out another owner, or for growth capital.

As with most financial terms, the term “mezzanine” can mean different things to different people — to me it means debt financing that is subordinated to bank loans.  The observations below are generally for companies with between $1 million and $3 million in EBITDA — larger companies will receive different (usually better) terms.

Mezzanine Financing:

Pros:

• A financing option to bridge the gap between equity and senior debt (bank) financing.  Banks typically want strong tangible assets and receivables and often personal guarantees.  Equity is expensive to give up.  Mezzanine fits in between these two options.
• Less pressure on cash flows because the mezzanine debt typically is non-amortizing (interest only payments, no principal payments) until the 5-year mark when the entire principal is due.
• Mezzanine lenders typically have more of a partnership mentality than bank lenders (your results may vary!) because they recognize the ebbs and flows of business results and panic less than bank lenders.
• Mezzanine loans are subordinate to senior bank loans.
• You can receive between 1 and 3 times your company’s EBITDA in mezzanine financing (for low EBITDA companies), but this depends upon the amount of senior debt ahead of the mezzanine and other factors.
• Less expensive than equity.  The cost of equity for smaller, private companies will usually be quite high (> 20%+ returns) which suggests that mezzanine financing is less expensive than giving up equity.

Cons:

• Expensive interest.  Mezzanine lenders can charge between 10 and 14 percent cash interest with maybe some additional non-cash interest (payment-in-kind or PIK that adds to principal) or equity warrants on top of the cash interest.
• Big payment in year 5.  Because the company is not required to make principal payments along the way, the company needs to be prepared to pay off the principal in year 5 or refinance the debt.
• Restrictions and covenants.  You have another voice at the table when making decisions about your company.  And, the mezzanine lender will institute covenants regarding your total debt amounts, cash flows, and more than you need to comply with during the term of the loan.

Common Terms:

• Cash Interest of between 12 and 14 percent annually.
• Non-cash interest (additional to principal, or PIK — payment-in-kind) or warrants or a combination.  This can be another 4-5% PIK, so the all-in interest can be as high as 17% or more.
• Warrants or some equity participation.  The mezzanine lenders are usually looking for some more participation in the upside of the company if it does well, so they are often asking to purchase some equity or to receive warrants to give them more upside potential.  Warrants are an option to purchase equity at a specified price, so the mezzanine lender will exercise if the company increases in value and their warrant is in the money.
• Prepayment Fees.  There will usually be prepayment fees as the lender does not want you to pay off the loan quickly — they want the chance to earn the interest that they expect.  The prepayment fee will usually decline over time.
• Subordination.  Mezzanine will be subordinated to senior loans, usually from a bank, but will obviously be senior to equity.
• Closing fee.  Closing fees can be high, such as 2%, because mezzanine lenders are usually SBIC lenders (small business investment company) and they need to pay a closing fee back to the US government and they want to cover that fee (at least, that’s the story they tell me!).

A high percentage of mezzanine lenders participate in the US government’s Small Business Investment Company program which is different than the SBA loans that you may be familiar with.  In this program, the mezzanine funds raise $1 of private capital and can usually get another $2 of capital from the SBIC program.  And, the capital from the SBIC program usually only costs a little more than the 10-year US Treasury Rate.  So, if their capital costs 3% and they are lending at 14%, they can usually make a good return for their partners.