Mezzanine Funding Meaning, Needs & Types

Mezzanine Funding Meaning, Needs & Types

The term mezzanine financing can be traced back to the French word "mezanin," which is literally translated as a balcony. 

As a result, mezzanine financing is often called second-tier debt because it's between first-tier debt (the type of debt you might see on a company's balance sheet) and equity ownership in the business.

Mezzanine financing is generally viewed as a lower-cost alternative to banks for small businesses who don't have access to capital elsewhere, which often means they're too small or too risky for traditional lending. 

In fact, some experts say that it can often be preferable to a bank loan because interest rates are typically at least 0.5% lower and often as high as 2% lower.

To help you understand mezzanine financing in greater detail, here are the basics of what it is, why you may need it, and how it compares with other types of financing.

Definition: What Is Mezzanine Financing?

Mezzanine financing is a type of debt that's placed between first-tier debt and equity in terms of priority. It's a relatively low-cost form of credit used to finance assets that a business could use to increase its earning capacity. 

These assets are tangible items with an inherent use or value beyond their initial cost.

It is regarded as a "mezzanine" because its risk level falls between secured loans offered by lenders such as banks and venture capital provided by equity investors who purchase a stake in the firm.

In the event of a default, secured lenders can take assets, but equity investors typically receive nothing. Mezzanine financiers may be entitled to some form of remuneration.

In many circumstances, mezzanine financing is structured so that the lender receives some stock in the firm at the outset or has the possibility to convert to ownership later on, such as if the loan is not returned on time.

How does Mezzanine Financing Work?

One of the riskiest types of debt is mezzanine financing, which fills the gap between debt and equity financing. 

It is superior to pure equity but inferior to pure debt. Additionally, because it frequently reaches rates between 12% and 20% per year, and on rare occasions even as high as 30%, 

it offers debt investors some of the highest profits when compared to other loan kinds. Mezzanine financing has an interest rate higher than the senior loan businesses generally obtain from their banks. 

However, it is still significantly less expensive than stock in terms of the total cost of capital. Therefore, mezzanine financing can be contrasted with either excessively expensive debt or less expensive equity. 

It also reduces the value of the company's stock. Finally, mezzanine finance allows a company to raise additional capital while enhancing its return on equity.

Businesses will seek mezzanine funding to assist with specific growth projects or short- to medium-term acquisitions. 

Long-term investors and present cash providers often make these loans. There is no requirement to repay the money obtained via equity financing in the case of preferred equity. 

The company has more liquid money to invest in the enterprise because no payments are required. Even a mezzanine loan only requires interest payments before maturity, providing the business owner extra cash.

All about the mezzanine fund structure

If you're looking for a new way to finance a business, mezzanine financing could be a good option for you. 

Any time that you have an asset that can generate cash or increase the value of your business, it's likely worth looking into.

As you'll see, there are various ways to structure this type of financing, so it's recommended that you contact your lender or mezzanine fund directly to find the right one for your needs.

What Type of Assets Qualify?

Mezzanine financing can be used almost anywhere on the balance sheet because it is typically structured to meet certain needs – not just on certain types of assets. 

Cash flow, for instance, is a major factor that's looked at when it comes to making this type of decision.

Moreover, common mezzanine financing uses include financing equipment purchases and working capital. 

However, you'll want to make sure that you work with your lender or fund to determine which type of asset will work best for your needs.

Why You Might Need It

The need for mezzanine financing is based on the cost of the fund structure itself and the cost of alternative uses for the funds. 

That being said, a lot depends on where you stand in your business cycle. For instance, your business may need access to an asset, but if you don't have the other two factors (the cost of the fund and its alternatives), then mezzanine financing may not be right for you.

Mezzanine Financing Compared With Other Options

Depending on your situation, mezzanine financing may be a good option for you. However, it's often recommended to compare mezzanine financing with other types of funding as well. 

For instance, mezzanine financing may be a good option for cash-poor companies that have set themselves up to be in a more profitable position.

At the same time, there are five main types of funding that you should consider as well:

1. Banks

Banks can provide short-term credit but typically don't offer long-term funding for small businesses. 

Furthermore, banks typically have a higher cost than mezzanine financing alternatives and aren't always an easy way to access capital.

2. Venture Capital

Venture capital is a form of funding that looks at a business's growth potential and overall health. 

The cost of this funding can range from 1% to 20% and typically comes in the form of investments in a company's owners.

3. Private Equity

This type of money normally comes from wealthy individuals (usually with backgrounds in finance and business) who hope to make an investment in your business, sell it to others, or receive some type of return on their investment over time. 

Lower-cost options are available for private equity, but you'll likely be at higher risk with this type of funding because it's not typically backed by any guaranteed balance sheet or income statement information.

4. Friends and Family

While this source of funding doesn't typically come with a set interest rate, it also doesn't require a lot of paperwork or any type of fee. 

The downside? This type of funding isn't likely to be a long-term solution, although you may be able to find some short-term financing options available that can last anywhere from three months to 24 months.

5. Factoring

Factoring is another type of funding that's becoming more popular since it works well for businesses with high-value invoices, particularly those with invoices that take 30 days or longer to collect payment on.

If you're looking for a new way to finance your business, mezzanine financing is one of the options that you should consider. It's a good option for many types of businesses and doesn't require any equity from your end.

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As always, you'll want to compare this type of funding with others to ensure it works for your needs. 

In most cases, though, mezzanine financing is an attractive type of funding because it will give you more flexibility than bank loans and other debt-based sources.

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