This post was written by David Jaffe.

Many lower middle market business clients looking for financing options often hear their bankers and financial advisors refer to mezzanine capital, but few understand its true purpose and function.

 As the reference to “mezzanine” suggests, it is necessary to understand what sits above and below the mezzanine level in a company’s capital structure in order to understand what mezzanine financing actually is. If you imagine your company’s capital structure as a layer cake, the top (or senior-most) layer is senior bank debt. This layer consists of standard, fully-collateralized term and revolving loans that are secured by first liens on a company’s tangible fixed assets, working capital, equipment and real estate. The bottom layer is the company’s equity, or owner’s capital, which represents residual claims on the company’s assets after the payment of all debts.

 Mezzanine capital, then, is the layer that sits below the company’s senior secured debt and above owner’s equity. It has attributes resembling both of its capital “cousins.” Like debt, mezzanine capital is a fixed obligation to repay over a term and accrues interest. Like equity, mezzanine financing has little or no collateral, is subordinate in right of payment to the senior debt, has more flexible repayment terms and a longer maturity than senior bank loans but earns enhanced equity-like returns through higher interest rates and limited participation in the capital appreciation of the company through warrants and other short-term payouts.

 Business owners often ask when is it appropriate to consider mezzanine financing. Why would a company use it rather than using traditional bank financing or simply putting in more equity? There are three situations where mezzanine financing is most useful: (i) as a funding source to enable asset diversification for owners of closely-held companies who are seeking liquidity, (ii) for management-led buyouts/buy-ins and other similar ownership transition transactions and (iii) to fund the acquisition of another company. In these transactions, mezzanine capital is useful as a complement to senior bank financing, not in lieu of it. However, inclusion of a mezzanine financing layer has several beneficial effects on the senior debt and the equity layers in the capital structure. These include the ability to obtain senior debt financing without personal guarantees, enhanced returns on equity capital and the ability to put more liquidity into the hands of owners and sellers at closing.

 It is important to recognize that mezzanine financing is not appropriate for every situation. But where a company is undergoing rapid growth, ownership transition or where transformational acquisition opportunities are present, an appropriately structured layer of mezzanine financing can mean the difference between closed deals and missed opportunities.

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