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What is mezzanine debt?

Mezzanine debt uses a combination of subordinate debt and equity options to raise money for an acquisition or business expansion. The lender/investor loans the company part of the money and invests in the company for the remainder. The debt is subordinate to the company's other debt, meaning it has claims on the cash flow after the primary debt has been paid. The investment is usually in the form of warrants or conversion options that are paid out when the company goes public or refinances all of its debt.

Mezzanine debt only works for companies with healthy cash flows. Service companies with little brick and mortar collateral required by traditional lenders, can benefit from mezzanine financing.

Mezzanine debt is for middle-market companies with total revenue of generally less than $500 million.

Because the lender/investor has two roles, they are concerned about short-term cash as well as long term equity gains.

Advantages/Disadvantages

Advantages
  • Good if your business isn't quite ready to go public, but needs funds for growth.
  • A company can leverage its cash flow by 4 or 5 times (cash flow of $2 million can raise $8 to $10 million), where a traditional loan will leverage 2 times (cash flow of $2 million can raise $4 million).
  • Very flexible loan terms
  • Doesn't require bricks and mortar as collateral.
Disadvantages
  • Your business must have a history of significant cash flow.
  • Investors expect higher return rate.
  • It takes a long time (3-6 months) to develop a mezzanine agreement.
  • Mezzanine debt is meant as a temporary level of financing, to be cashed out when the company goes public or refinances all of its debt. Despite this, mezzanine lenders are longer-term investors than angels or venture investors (usually 5-8 years).

Legal requirements

You are not allowed to advertise ownership interests in your business or sell to people you do not know unless you have registered with the SEC (Securities and Exchange Commission). Registering with the SEC is a cumbersome process, and few non-public companies go through the process.

You can, however, sell an ownership interest to people who meet the SEC requirements for an "accredited investor" through a private placement. There are multiple ways that someone can be an accredited investor, but usually it means they have a net worth of $1 million at the time of purchase. Click here for complete information.

Private placement means that the sale was made to someone known to the financial intermediary or the seller; i.e. there was no advertising to the public at large.

Even if you use a private placement to an accredited investor, it is strongly suggested that you work with an attorney experienced in private placements.

The difference between angels and early stage venture investors

Angel investors are wealthy individuals who invest in businesses on a part-time basis. Early stage venture investors are professional investors who invest for a living.

  • Angels are willing to invest in people - they like the founder and the idea. Venture investors are looking for the highest chance of success and profit
  • Angels want to be part of the process of growing the business and are more open to how that is done. Venture investors want to use their professional, "proven" teams to grow the business quickly and then sell their interest.

Expectations of early stage investors

  • You will be open to their ideas and use their strategies.
  • Regular communication.
  • You will have full disclosure to the investors - both the good and bad.
  • Decisions are made on what is best for the business, not what is best for the owner or what has been done before.
  • Books and records will be properly kept.
  • Costs are kept to a minimum until the company reaches breakeven.
  • You agree to sell the company within a 2 to 3 year period.

Ongoing Responsibilities

  • Regular financial reporting to investors (quarterly)

Online Sources of Capital

The Internet has opened new avenues for financing a business. Person-to-person lending, dubbed Banking 2.0, allows individuals to lend to each other at a set rate on a certain timetable and offers a mechanism for tracking and payment. On these sites you can post your business plan and potential lenders (individuals) can decide whether they want to loan to you. Most sites require that you have a good credit score (640 or higher) to participate.

It is still too early to know the downsides of online lending for borrowers. However, a few have been noted:
  • The loans are fixed, with both principal and interest due each month. If you can't make a payment, you have to negotiate online (if that is even possible). It is much easier to go visit a local lender and negotiate face-to-face.
  • These private lenders aren't regulated, so the documentation and fine print are critical. You should definitely consult an attorney before signing a loan agreement.
  • Never advertise shares for sale at any site. It is illegal to advertise securities to the general public.