Mezzanine financing is a form of funding that is positioned partway between the equity and debt financings used by a business. It is designed to provide cash to an existing business that requires the funds to grow, or for a leveraged buyout, or a corporate restructuring. The borrower in a mezzanine financing situation is usually not publicly held, and so does not have access to the public markets as a more ready source of cash. This type of financing is usually obtained from smaller lenders who specialize in mezzanine financing, rather than from more traditional banking institutions.
Mezzanine financing is typically structured as:
- Convertible debt that can be swapped by the lender for company stock if the price of the stock rises.
- Debt with a significant number of attached warrants that allow the lender to acquire company stock if the price of the stock rises.
- Preferred stock that earns a dividend, and which may have special voting rights, the ability to convert to common stock, or other special features.
In essence, the lender wants to participate in some way in any subsequent gains in the value of a borrower's stock, while avoiding any declines in the value of the stock.
Mezzanine financing, if structured as debt, is usually junior to the debt of a company's more traditional lenders, such as the bank that issues its line of credit or any long-term loans. This means that, in the event of company cash flow troubles, the holders of senior debt are paid first from available cash, while those in a junior position are paid only from any residual cash available once the claims of all senior lenders and creditors have been satisfied.
Given the increased riskiness of being in a junior position, the lender of mezzanine financing wants to earn an unusually high return that is usually in the range of 20% to 30% per year. The lender may also charge a considerable up-front arrangement fee. A borrower may not be in a position to make ongoing interest payments in the 20% to 30% range on an ongoing basis, which is why the use of warrants and conversion features are heavily used to give the lender an alternative method for achieving its return on investment goal. This also means that principal is not scheduled to be repaid until the end of the loan period, and may be paid back with company stock, if the lender can realize an adequate return from taking this form of payment.
Mezzanine financing can also be used in a leveraged buyout situation, where it is used as a stopgap measure to provide short-term financing until a lower-cost and longer-term arrangement can be made.
Though mezzanine financing can provide a considerable amount of cash, it has a number of downsides. First, the lender may impose a number of restrictive covenants to protect its investment. Second, the lender may end up being a large shareholder in the business, and so is in a position to influence decisions made by the company. Third, it is one of the most expensive forms of financing available. And finally, mezzanine financing is only available after a prolonged investigation by a prospective lender.