Mezzanine finance is a hybrid debt equity instrument that is being increasingly used by technopreneurs around the globe, in different forms and use cases, as it is largely non-dilutative of their equity, usually does not require their personal surety and can be easier to acquire than either bank debt or equity investment. Here’s how it can be used and how it works.

Mezzanine (or mezz) finance is a structured way to borrow money that sits between traditional equity and debt financing. It ranks below senior and bank debt (and is therefore subordinated debt) but above equity and shareholders loans (hence the name mezzanine), and usually has higher interest rates and an equity kicker to compensate the lender for the higher risk of not being first in line repayment queue.

Mezz finance is quite flexible and can be structured such that only the interest (and not the principal) is paid during the term of the finance, or is deferred and accumulated until the principal is repaid. Collateral of the company or the technopreneur is not usually required.

One thing to watch out for is restrictive covenants, for example restrictions on taking on any further senior debt during the term of the mezz finance.

An equity kicker gives the debt provider the right to buy equity in the company at a predetermined price or formula in the future, typically agreed to be a certain event such as the next funding round, a particular financial milestone, or on the sale of the company.

Mezz can be used for both short term and longer term use cases, which will also depend on the stage of evolution (early vs growth vs private equity) of the startup, such as:

1. Extending runway – this is short term by definition and can be used at all company stages, allowing the startup more time to improve its KPIs and increase its valuation before raising its next equity round, it is typically repaid at the next equity round such as with Venture Debt
2. Growth capital – this can be a short term or longer term use case and can be used at all company stages, with the term perhaps best linked to a financial milestone relating to the growth initiative that is being financed e.g. new product launch, new GTM channel
3. Restructuring your balance sheet – this is longer term in nature, where mezz can be used to build a healthier balance sheet, for instance retiring bank debt and replacing it with mezz
4. Financing acquisitions – this can be short term (e.g. finance until the next equity round) or longer term, perhaps linked to a financial milestone related to the results of the acquisition
5. MBOs/LBOs – longer term where the private equity firm uses mezz as part of the debt stack, again creating more space for the technopreneur/management to own or earn more equity

Mezz instruments that are commonly used are Venture Debt, Preference/Preferred Shares and Convertible Securities, but mezz does not have to fit into any of these categories.

Venture Debt is used to bridge to the next equity round, so is short term in nature. Debt providers evaluate the company and its probability of raising the next round in the same way as an equity investor, taking into account the credibility of the existing investors and their appetite to invest in the next round. The equity kicker is often applied at exit.

Preference/Preferred Shares – long term in nature, with the fixed dividend or portion of the profits paid before the ordinary shareholders, either at a liquidity event or when dividends start accruing – but with no voting rights.

(Not to be confused with the shares by the same name issued to VCs that have the same voting rights as ordinary shareholders,  but also have the rights as above in down-side liquidity events, or the economic benefit of ordinary shareholders in up-side liquidity events.)

Convertible Securities which give the option to the debt provider to convert at an agreed event in the future at an agreed conversion rate – this can potentially be quite dilutative, particularly if used in the longer term, but can be useful for bridging rounds such as with a Convertible Loan Note instrument.

How do you go about raising mezz? There are many private debt funds out there. You can also explore VCs and PEs (some of which have dedicated mezz funds), insurance companies (under their Alternative Asset allocations), and banks. You can use the same type of pitch deck as for raising equity ,when approaching mezz finance providers.

Of course we would recommend that you use a regulated advisor to help define and navigate your overall corporate finance strategy,  including how mezz can best work for you, and to do the work in arranging the finance.