What is mezzanine financing and why are companies using it to fund expansion plans?



What is mezzanine financing and why are companies using it to fund expansion plans?

 Do you own a startup? Have you been finding new ways to borrow capital for expansion? Do you lack the collateral to borrow money from banks? I have come up to update you about this amazing source of financing which is being used by many growing startups to help them in their journey of building their companies and making an impact on this world. Before I explain to you what mezzanine financing is, let me familiarize with the below 2 terms:


  • Senior Debt: This is the debt that holds priority over all other loans the company might have as well as over the equity shareholders. This means they get paid first when wounding up the business.
  • Equity: They are the shareholders of the company and own shares of the company which gives them ownership for the corresponding shareholding. Equity does not carry any fixed interest and therefore has the highest cost of financing. Because even if the company makes losses for 10 consecutive years, they get paid nothing in return (dividend) for their money.


So, What is mezzanine financing?

Mezzanine financing is a mix of debt and equity. It is provided by mezzanine lenders to small companies and startups, basically private equity investments. This is a form of alternate investment for these mezzanine finance providers. It involves borrowing money,i.e., taking loans from mezzanine lenders for your company without providing for any collateral in return. But why would someone give you this kind of unsecured money? There are 2 reasons for that:

 Interest Rate: Mezzanine loans are very high in risk and therefore have a higher cost than senior debt but lower cost than equity. To simplify, it has a very high interest on the money lent. Mezzanine loans are between senior debt and equity. It carries a higher return than senior debt but a lower return than equity. In terms of redemption of principal amount senior debt is paid first, mezzanine second and at last the equity shareholder. See the below table to understand the standing of Mezzanine finance:


Equity Stake: Since lending to small companies is very risky and also there is no collateral, these mezzanine lenders make a contract with the company that in case of default, they will exercise the warrants or options as mentioned in the contract to acquire an equity stake in the company without any restrictions. They are free to keep the stake or they may sell the stake to some other entity on their discretion.

Things to keep in mind:
  • Cash Flow: Mezzanine financing is accessible only to those companies which are cash flow positive because if you are losing cash you wouldn't be able to meet up the interest liability.
  • Amount to borrow: Keep caution while deciding the amount to borrow, the usual recommendation is you should borrow money only between 2 to 5 times your positive cashflow.
  • The intention of lender: Sometimes when you have just started, you do not of full control over the future of the company. Try to gauge the reputation and intention of the mezzanine lender as if someone who always sells his stake when there is a default will only make the condition worse for you as your valuation will drop further. Try to contact that person who might stick to your company for giving support even if you default. It will be a win-win for both the business and the lender.
  • Contractual obligations: Don't overboard your firm with a lot of burden by promising a lot of benefits for the lender. It is obvious that since you are a small firm, the lender will have more say in the contract but see if you can get a better deal first.
Advantages of Mezzanine Financing:
  • Flexible Structure: This source of capital is flexible in nature because of being a hybrid of debt and equity. It carries the attributes of both by giving the lender the opportunity to convert his debt into equity by exercising warrants or options in case there is a default.
  • No Collateral Requirement: The majority of debtors will ask you for some kind of security but not in case of this source. Since there is no security requirement, even if you had something which you could give for collateral, the same can be used to get extra funding from other sources.
  • Startup Expansion: This is an excellent source of capital to expand your company when you have a positive cash flow and can easily meet the interest obligations.


Thanks for reading!

I hope you found this post useful, For the latest updates follow @ rdhmfinance on Instagram!

Comment about any query you had like me to address.

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