Mezzanine financing is potentially an attractive win-win lending structure which can help your company achieve landmark growth. It’s been a staple in private equity firms, and is now entering the mainstream of direct lending to businesses.

What is mezzanine lending? Here’s a definition from Investopedia:

Mezzanine financing is a hybrid of debt and equity financing that gives the lender the rights to convert to an ownership or equity interest in the company in case of default, after venture capital companies and other senior lenders are paid. Mezzanine financing, usually completed with little due diligence on the part of the lender and little or no collateral on the part of the borrower, is treated like equity on a company’s balance sheet.

Instead of an equity investor delivering the entire sum of additional capital needed for expansion, a mezzanine lender can be incorporated into the deal to cover some of that capital.

Mezzanine financing is appropriate when a company can demonstrate a solid track record in the industry and is seeking funding for a significant expansion. If the business has a good reputation; a reliable product; a history of profitability; and a viable expansion plan, it should consider seeking mezzanine investors.

The typical interest rate for mezzanine financing is high, ranging from 12 to 20%. Accordingly, it’s high-risk with a potential for high-return.

From the borrower’s perspective:

The borrower benefits by gaining a capital partner without the large dilution of equity which would be part of the package with a private equity group or a traditional investor.

The lender is typically savvy about the company and industry, and has incentive to help the business grow. They may take greater involvement in the structure of the deal and may deliver additional capital infusions

Interest on mezzanine debt is tax-deductible, which is not the case in traditional lending and lowers the actual costs. While the interest rate is high, the goal is for quick and stable expansion, enabling the borrower to restructure the mezzanine financing into one senior loan at a lower interest rate.

It’s a less dilutive way to get increased capital investment, compared to equity investors.

Lastly, borrowers may roll their interest into the loan balance.

The risks for the borrower include the sacrifice of control of the company along with the loss of equity. If growth fails to meet expectations, the high interest rates may persist longer than planned and be crippling.

From the lender’s perspective:

Mezzanine financing is attractive to lenders seeking to build a strong relationship with a business, where they can play a more authoritative and value-added role.

The lender benefits from contractually obligated interest payments on a defined schedule, which ranges from monthly to annually. This payment on the high interest rate of the debt is a welcome return on investment.

Mezzanine financing typically include a small amount of equity or an option to purchase equity in the future. If the borrower leverages the loan into major success, that small slice of ownership can translate into a tremendous rate of return (ROR) for the investor.

In conclusion:

Mezzanine direct lending is best suited to specific circumstances when a company is pursuing a roll-up and requires capital for a series of acquisitions. If you’re not well versed in this financing model, it’s worth learning more.