Mezzanine Debt Structure

Businesses raise capital from several different sources, most notably debt and equity. Debt financing occurs when businesses issue bonds and sell them to investors or take out loans from banks to fund projects. Equity financing is the result of selling shares to investors who are buying portions of ownership in the company itself. However, businesses may have reasons to avoid both these options to some degree. Debt financing can create serious financial burdens in the future, while equity financing dilutes company ownership. A common solution to this issue is a mezzanine debt structure.

Definition

Mezzanine refers to a layered, or multi-platformed, structure. In this case, it means that the business uses multiple types of financing for its projects. A mezzanine structure allows for more than just debt and equity options. It also makes a middle ground by using a combination of the two types; this allows the company to raise funds from various hybrid debt instruments that have characteristics in common with both equity and debt tools.

Types

There are several types of mezzanine instruments that companies have created in this complex structure. One of the most common is preferred stock, which is sold like common stock but does not have the same attached voting rights. It does, however, guarantee a certain amount of dividends according to the company's plan, which makes it as much like a bond as a share of stock. If the company fails and there is any money leftover, investors with preferred stock are paid before holders of common stock. Companies also use convertible bonds, which start out as bonds but allow investors to change them into stock in the future.

Subordinated Debt

Mezzanine is classified as subordinated debt, or debt that holds second place to important senior debts that tend to be larger, secured by assets and made by major institutions. The terms may be interchangeable. Typically, any type of subordinated debt is considered mezzanine debt as well. Because this type of debt is risky for lenders and investors, businesses tend to offer higher interest rates and better returns in order to finance these instruments.

Purpose

Mezzanine debt provides an ideal middle ground. When a company does not want to sell more stock for fear of giving up control of the company, it can use preferred stock to continue financing without the same dangers. Likewise, mezzanine debt is often possible when the company has maxed out its senior debt limits but still needs funding in order to fund growth or expansion.