Mezzanine financing guide for startups

What is mezzanine financing?

Mezzanine financing is a hybrid funding method that combines elements of debt and equity to help entrepreneurs raise growth capital. Unlike traditional loans, it allows lenders to convert debt into equity if the borrower defaults, bridging the gap between senior debt and equity financing.

This type of funding is especially popular for expansions, acquisitions, or other high-growth initiatives, offering early-stage startups a flexible yet complex avenue to secure funding without immediate equity dilution.

What are the benefits & risks of mezzanine financing?

Mezzanine financing is often used by companies that need more funding than a traditional loan can provide but are not ready for venture capital or public offerings. Before you make a decision, here’s a breakdown of the pros and cons of this type of financing:

Benefits of mezzanine financing

The pros of mezzanine financing include:

• Flexible structure: Mezzanine financing can be customized as per your business needs, whether for expansion, acquisitions, or working capital.
• Preserves ownership: Unlike full equity financing, mezzanine debt financing allows you to retain more ownership. The repayment structure typically revolves around loan terms rather than giving away shares.
• Less expensive than equity: Since this financing is debt-based, it is generally cheaper than selling equity, where you might have to give up a significant share of future profits.
• Tax advantages: The interest payments on mezzanine debt are often tax-deductible, reducing the overall cost of financing for your business.
• Growth potential: Mezzanine financing provides additional working capital, enabling you to pursue growth opportunities without immediately diluting control.

Risks of mezzanine financing

In contrast to these benefits, the cons of mezzanine financing include:

• Higher interest rates: Compared to traditional loans, mezzanine loans usually come with higher interest rates, making them a relatively costly form of debt.
• Ownership dilution: While less than full equity financing, mezzanine deals may still involve giving the lender equity or warrants (rights to purchase shares later), which could dilute your ownership over time.
• Debt burden: Adding mezzanine debt increases your company’s debt-to-equity ratio (a measure of financial leverage). High ratios might make it harder to secure future financing.
• Restrictions on operations: Loan agreements may include covenants (binding conditions), such as limiting additional borrowing, setting financial performance targets, or restricting payouts to employees and business owners.
• Risk to lenders and borrowers: Mezzanine loans are unsecured and come with a higher risk, meaning they are not backed by collateral. In case of bankruptcy, mezzanine lenders may lose their investment as senior debt holders get priority. For the borrowing company, failing to meet payment obligations can lead to default.
• Time-consuming process: Negotiating mezzanine financing can take several months, requiring thorough preparation and documentation.

When should you consider mezzanine financing?

As a startup founder, you might find mezzanine financing particularly useful when you need capital for expansion but want to avoid giving up significant control of your business.

Here are some key scenarios where mezzanine financing might be the right choice:

Expanding your business

If your startup is scaling operations, launching new products, or entering new markets, mezzanine financing can provide the required capital. Unlike traditional bank loans, it is more flexible and often interest-only until maturity, allowing you to focus on growth during the initial term.

Preparing for a major transaction

• Mergers and Acquisitions (M&A): When acquiring another company or merging with one, mezzanine financing can fill funding gaps without requiring substantial equity investment.
• Leveraged buyouts (LBOs): This financing can help you maximize borrowing capacity to acquire another business, particularly when aiming to minimize upfront equity investment.

Refinancing existing debt

If you want to repay or restructure higher-cost debt, mezzanine financing can help improve liquidity. It’s a practical option if you have a clear business plan to use the extended repayment timeline to strengthen your financial position.

Management or shareholder buyouts

• Management buyouts (MBOs): If you or your team plan to take over ownership from current investors or a parent company, mezzanine financing can provide the capital needed.
• Shareholder buyouts: Use it to purchase shares from retiring founders, passive investors, or stakeholders exiting the business.

Recapitalization for liquidity

If your company needs to adjust its mix of debt and equity, mezzanine financing can help. For instance, you can use it to distribute dividends or repurchase shares while keeping ownership within the current team.

Long-term growth projects

Mezzanine funding can support organic growth initiatives like product development, marketing, or facility expansion. Since the capital comes with a longer repayment window, it offers breathing room to execute these plans.

Mezzanine vs. other types of financing

Choosing the right financing option for your business depends on your goals, growth stage, and risk tolerance. Mezzanine financing is one option, but it's important to understand how it compares to alternatives such as:

Venture capital

Venture capital (VC) provides funding to startups in exchange for equity, targeting startups with high growth potential. Plus, these investors often bring more than money to the table, offering strategic advice, industry connections, and access to networks that can help accelerate growth.

Traditional loans

Traditional loans are a straightforward option for businesses that can meet stringent requirements, such as strong financial records and collateral. These loans generally have lower interest rates when compared to mezzanine financing.

Equity financing

Equity financing entails selling your company shares to raise capital, making it a good option for businesses that have limited cash flow or those unwilling to take on debt. This type of financing often attracts long-term investors who align with the company’s vision and are willing to wait for returns.

How to secure mezzanine financing?

Securing mezzanine financing requires careful preparation, strategic negotiation, and presenting your business in the best possible light. Follow this step-by-step guide to guarantee a smooth process:

1. Assess your financing needs

Start by identifying why you need the financing—whether for expansion, acquisitions, or improving working capital.

• Define the exact amount you require and evaluate how the additional capital will influence your cash flow and growth prospects.
• Analyze if mezzanine financing aligns with your business’s capacity to generate steady returns to meet repayment obligations.

2. Strengthen your business fundamentals

Prepare your business for scrutiny by organizing your financial records, including:

• Audited P&L statements
• Balance sheets
• Cash flow forecasts

These documents should clearly demonstrate your company’s financial health and repayment capability. Additionally, address any outstanding debts and improve your credit score to establish credibility with lenders.

3. Identify potential lenders

Research lenders specializing in mezzanine financing, such as investment banking firms, VC firms (venture capitalists), or private equity firms that align with your industry and growth objectives. Also, leverage professional networks, financial advisors, and industry events to connect with reputable lenders who understand your business sector.

4. Prepare a comprehensive pitch

Create a compelling business presentation that includes:

• Your company’s history, mission, and vision.
• Detailed market analysis showcasing opportunities and competitive advantages.
• Revenue projections and the expected impact of the financing.
• Risk management strategies to address potential lender concerns.

5. Negotiate deal terms

To negotiate favorable terms:

• Understand your company’s valuation to avoid over-dilution if the deal involves equity conversion.
• Negotiate terms for interest rates and repayment schedules that align with your business’s cash flow capabilities.
• Carefully review any financial or operational conditions attached to the financing, making sure that they are reasonable and manageable.

Also, conduct due diligence by reviewing your financial records, legal documents, and overall business operations

7. Finalize the agreement

Work with a legal expert to review the financing agreement thoroughly and make sure that the terms are clear and fair, especially regarding high interest rates, repayment schedules, and equity conversion clauses. Additionally, make sure you fully understand the implications of any attached conditions before signing.

Wrap up

Mezzanine financing offers startups a unique opportunity to access growth capital without immediate equity dilution. By understanding its structure, benefits, and associated risks, you can determine if it aligns with your business goals. Whether you're planning an expansion, acquisition, or scaling operations, this hybrid form of financing can effectively bridge funding gaps.

However, preparation is key—thoroughly assess your financial health, present a compelling growth plan, and negotiate terms that align with your company's long-term objectives. 

That said, if you’re looking for alternative funding methods to fuel your startups' growth, consider Rho’s Corporate Cards¹. 

With them, you can make the purchases you need to keep your business operations running smoothly, all while enjoying up to 1.25% cashback². Combined with our expense management platform, you can make more strategic spending decisions and gain the insights you need to take control of your budget.

Want to learn more? Schedule a demo today.