Mezzanine capital is a type of financing plan for a business that combines loans from investors with equity offered to those same investors. The general idea behind it is that the business will pay back the lender in equity if it is unable to repay it with capital. For a business, mezzanine capital is a way to gain quick and substantial financing and improve its balance sheet. Investors in this arrangement benefit if the business grows because they will either get their loan repaid with interest or have their shares grow in value.
Borrowing money is often a necessary process for small businesses that may initially lack the capital to compete with well-established forces in the market. Unfortunately, the borrowing options for such nascent businesses are often limited, as they may lack the track record to attract significant capital from banks and aren’t big enough to go public on the open market. For such small businesses, mezzanine capital is one possible way to raise the money they need to grow.
The basic structure of the mezzanine capital arrangement is a simple loan from some investment entity to a business. Such loans are usually secured even though there is no collateral offered and without the business having a proven track record of earnings to prove its long-term worth to the investors. Since that is the case, the interest rates offered to the lender upon repayment are significantly higher than an established business might be able to offer.
If the business can’t repay the loan, then the lender is repaid with equity in the business in the form of shares of preferred stock, which essentially gives the lender a share of the ownership of the business. The loan of mezzanine capital is generally subordinated to other business loans, which means that the business will only begin to repay it after its senior debt, like bank financing, is repaid. Given this, it is a distinct possibility that the lender gains equity.
Another benefit of mezzanine capital is that the business may include it on its balance sheet, thereby making the business look more attractive to investors and thus opening the possibility for other forms of financing. The business usually regains control over operational decisions, although the lenders may have some say depending on how much equity in the business they gain from the arrangement. This equity is the lure for the investors, as they may have the opportunity to cash their shares in if the business becomes a bigger factor in the market at some point in the future.