Mezzanine Financing

See Also:
External Sources of Cash
What Does A Lender Want To Know
Finding The Right Lender
Due Diligence on Lenders
Weighted Average Cost of Capital (WACC)

Mezzanine Financing Definition

A mezzanine lender, provider of mezzanine financing, functions similar to a bank in terms of providing a source of capital for companies. They get their capital from private investors who look to make a profit off of the investments the mezzanine lenders make. Often times, the firm is structured as a limited partnership for tax purposes.
There comes a time in every company’s life cycle when the company and/or the entrepreneur need some more cash. Perhaps the company needs more working capital or some additional money to help fund an expansion. Or, maybe the entrepreneur feels that it’s time to reap the benefit of all those years of hard work. Whichever the case may be, the entrepreneur will be faced with many different financing options. An interesting and often over-looked option is that of bringing in a private equity partner in the form of mezzanine funding.

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Mezzanine Lenders

Mezzanine lenders are similar to banks … but they are not banks. The interest they charge is going to be higher than what commercial banks charge. Many entrepreneurs blench at the thought. But consider, other than maxing out your credit cards, what other alternatives do you have? Mezzanine lenders will charge you approximately what credit cards charge you. Their cost of capital ranges from the high teens to low twenties (18-23%). This may seem quite high, but if your enterprise is so risky that a bank will not touch it, then it is only fair that you reward someone for taking on this extra risk. Also, what bank would feel comfortable about an entrepreneur taking the bank’s money and pocketing it for personal gain? No bank would. Mezzanine lenders do.
Mezzanine lenders can also benefit the firm in other ways as well. They can help entrepreneurs upgrade their talent resources by finding professional management staff. They can help with finding better technology, placement with new customers or help you find sourcing alternatives. Remember, the best business partner is someone who brings more than just money to the table.
Financing typically comes in the form of either a loan and/or equity interest. Sometimes the debt is convertible into equity. Many people worry when they hear that their equity is compromised. This is actually not so. Mezzanine lenders are open to having their equity interest bought out. Think of it as a “pop” for taking on the risk.

Purpose of Mezzanine Financing / Mezzanine Capital

So, what is the purpose of mezzanine financing or mezzanine capital? First, let us consider a common business dilemma: 1) lack of working capital or 2) lack of funds for capital expansion. Entrepreneurs by nature are optimists and passionate people, especially when it comes to their companies. They want and need a financial partner that can grow with them. Typically, your first option of choice is your friendly, neighborhood commercial bank. There are several issues that one often encounters here:
1. Debt – Is your company too leveraged for the bank to accept?
2. Profitability – Is there enough profit to sustain the enterprise?
3. Cash Flow – Is your company generating enough cash to pay the bills?
4. Inventory – Are you turning it over fast enough?
5. Equity – Do you have enough skin in the game?
If your firm can pass the litmus test, then by all means you should go with your friendly, neighborhood commercial bank. They are typically your cheapest source of money.
Next, let us consider a more interesting question from the entrepreneur’s perspective. I’ve worked this long and hard. Don’t I deserve to be rewarded? Don’t I deserve to be a millionaire? If you don’t already have a million dollars in the bank, then the bank will probably be the first to tell you, “No.” So what’s a hard-working entrepreneur to do? Surprisingly, this issue is one that is faced by countless business owners as they face retirement or just want to “take some chips off the table” for security purposes.
The above cases represent typical situations where it makes sense to consider other financing options such as a Mezzanine Debt Financing.

Recapitalization Example

Below are some typical scenarios where you might want to consider working with a mezzanine lender:
1: Company needs capital infusion for either working capital or CAPEX.
2: Entrepreneur would like to buy out a partner.
3: Entrepreneur would like to “take some chips off the table” to provide security for his/her family.
4: Entrepreneur would like to pass along management to next generation.
5: Entrepreneur would like to share some equity with management staff and/or employees.
6: Entrepreneur would like help with selling the company to a strategic buyer at a good profit so s/he can retire.

Mezzanine Recapitalization: Conclusion

Entrepreneurs should consider mezzanine lenders a strategic financial resource. They many not always be your first choice, but they just might be your best choice. They have a higher cost of capital than banks. But, for the money, they provide a lot of strategic options to the entrepreneur that commercial banks could not be party to.
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