As a small business owner, you look to either a bank for a loan or to a private investor for an equity investment, to fund your business growth initiatives, including organic growth, business acquisition, operational improvement, buyout, and recapitalization. While bank loans and private equity investments are widely used funding options, they both have funding attributes that are considered as drawbacks by many small business borrowers.
For example, a bank loan comes with stringent lending standards and terms, lengthy loan approval process, floating interest rates, and requirements for collateral and even personal guarantees. Moreover, a bank loan is amortizing (paying off a portion of the principal with each payment), which can be a significant drain on the business’s cash flow during the same time when the business needs cash the most. For private equity investment, it is a lot more expensive and dilutive, and normally requires a controlling interest and management control in the business. Moreover, a private equity investor could force an ultimate sale of the business within 3-6 years.
Fortunately, there is a third funding option available, which combines many of the desirable funding attributes offered individually by bank loans and private equity investments. It is called Mezzanine debt or Mezzanine capital.
What is Mezzanine debt? : Mezzanine debt, aka Subordinate debt, is a combination of typical bank loan debt and private equity investment. It is a hybrid debt, blending the traditional debt features such as interest with equity characteristics like warrants. For borrowers, the mezzanine debt offers a much more flexible, supportive, and long-term loan solution, compared to a bank loan, and a much less expensive, dilutive, and controlling partnership, compared to a private equity investment.
How Mezzanine debt works? : Mezzanine debt is typically structured as a long-term, fixed-rate, interest only, and non-amortizing debt, with a balloon payment of principal due at the end of the term. Some mezzanine debts offer Payment-In-Kind (“PIK”), which defers the interest payments in future, while others require equity participation via a warrant or a direct equity co-investment. The amount of mezzanine debt a business can raise is typically the difference between its current total debt and the maximum debt it can afford to take, typically in relation to its projected cash flow, EBITDA, and/or tangible assets over the investment term.
Comparison of Mezzanine Debt with a Senior Debt (a bank loan) and a Private Equity Investment: Here is a comparison of typical funding transactions:
| Senior Debt | Mezzanine Debt | Private Equity | |
| Approval/Due Diligence Time | Long | Short | Short |
| Collateral | Yes | Little to None | No |
| Personal Guarantee | Yes | No | No |
| Loan Customization Standards | Rigid | Flexible | Flexible |
| Loan Structure | Revolving Debt | Debt w/ Warrants | Preferred Stock |
| Investment Horizon | Short Term | Long Term | Long Term |
| Seniority/Security | Senior Loan | Junior Loan | Unsecured |
| Interest Rates | Floating | Fixed | Fixed |
| Loan Amortization | Yes | No | No |
| Coupon Deferral | No | Possible | N/A |
| Risk Tolerance | Low | Medium | High |
| Required Return | Low | Medium | High |
| Hidden Costs | Personal Guarantee | None | Loss of Control |
| Equity Dilution | None | Low | High |
Each of these options has its pros and cons; and as a small business owner, it is your job to decide which option works best for your situation.