Mezzanine financing is a form of funding having features of both debt and equity financing, which gives the lender the right to claim ownership of equity or stock in the company in case the latter defaults on the repayment of the loan. Hence, mezzanine financing may result in lenders – or investors – gaining equity stake in the business ventures or warrants for purchasing equity at a later date. This may increase an investor’s rate of return (ROR) substantially. In addition, mezzanine financing providers may receive contractually obligated interest payments monthly, quarterly, or annually. A mezzanine loan may be the best option for business owners keen to take their firm to the next level but don’t have the working capital to make it happen.
Borrowers generally opt for mezzanine finance as the interest paid is tax-deductible, which reduces their tax liability. Also, mezzanine financing is more easily manageable as the lender may insist on minimal collateral from the borrower, and it is generally available within a shorter span of time. Moreover, if the borrower cannot make an interest payment as scheduled, some or all of the interest can be deferred. This option may not usually be available for other types of debts. However, as mezzanine finance is considered relatively risky, lenders are very selective and usually give such funds only to credit-worthy and financially sound firms.
Though every SME may not qualify for it, small businesses that are well-established with adequate debt-servicing capacity or have a good history of being profitable and have big growth plans would be eligible to get mezzanine capital. In fact, mezzanine finance has removed many obstacles small businesses face while raising long-term funds. Furthermore, small business owners should also remember that the minimum rate of return expected by most mezzanine investors may range between 10% and 30% per year. Though this may appear a bit high, the annual rate of return set by many venture capitalists is between 25% and 60%, depending on the stage of investment.