What is mezzanine financing? How it works and when to use it
- What is mezzanine financing?
- How mezzanine financing works
- Typical terms, rates, and covenants of mezzanine loans
- Pros and cons of mezzanine finance
- When to use mezzanine debt vs. equity
- Who provides mezzanine debt funds and why
- 5 steps to secure funding from mezzanine lenders
- Tracking mezzanine interest and warrants in your finance stack
- How Ramp helps you keep costs under control
Mezzanine financing combines features of both debt and equity financing to help fund specific growth investments. This hybrid financing combines subordinated debt with equity features such as warrants or conversion rights, giving lenders higher returns while preserving most of your ownership stake.
However, interest rates for mezzanine financing reflect the level of risk involved in this type of financing. These typically fall between 12–20% through a mix of cash interest, payment-in-kind (PIK) interest, and equity kickers. In exchange, you get flexible capital that sits between senior debt and equity in your capital stack, paid after your bank loans but before equity holders.
What is mezzanine financing?
Mezzanine financing is hybrid capital that combines features of debt and equity. It typically takes the form of subordinated, unsecured debt financing with an equity kicker, such as warrants or convertibility, that gives lenders upside potential. In the repayment priority pecking order, it sits between senior secured debt, which has first claim on assets and cash flows, and common equity, which is last in line.
Warrants
A warrant is a security that gives the holder the right to purchase a company’s stock at a set price in the future. In mezzanine financing, warrants act as an equity kicker, letting lenders share in the company's upside value if it grows.
Where mezzanine lending sits in the capital stack
Mezzanine financing sits between senior debt and equity in a company’s capital structure. Because mezzanine is subordinated, lenders rely on intercreditor or subordination agreements that define payment priority and outline remedies in case of default.
Here’s how they differ across repayment priority, security, cost, and ownership dilution:
| Dimension | Senior debt | Mezzanine debt | Equity |
|---|---|---|---|
| Repayment priority | First to be repaid from cash flows; first claim on collateral in default | Paid after senior debt but before equity holders | Paid last, only after all debt obligations are met |
| Security | Secured by hard assets (equipment, real estate) and working capital assets (A/R, inventory); liens filed | Typically unsecured or second-lien; relies on subordination agreements | No security; represents an ownership stake |
| Cost of capital | Lowest rates due to lowest risk | Higher coupons plus PIK interest and equity kickers; blended mid-to-high teens | Most expensive; investors expect highest returns to offset last-in-line risk |
| Dilution | No dilution; you keep full ownership | Limited dilution through warrants or conversion features (5–15% typical) | Dilution proportional to new equity raised (e.g., 30% capital raised = 30% ownership given up) |
How mezzanine financing works
Mezzanine financing bridges the gap between what senior lenders provide and your total capital needs. The process typically goes through these steps:
- Identify the funding gap: Turn to mezzanine capital when senior debt can’t cover all your funding for acquisitions, growth, or buyouts, especially if you want to avoid heavy dilution. Mezzanine fills that gap without forcing a big equity raise.
- Model cash flow coverage: Lenders review your historical and projected EBITDA, fixed-charge and interest coverage ratios, and run stress-testing to ensure you can support both cash and PIK interest (which compounds into principal)
- Structure return components: Mezzanine deals aim for mid- to high-teen returns using a mix of cash interest, PIK interest, and equity kickers like warrants or convertibility. Because pure cash coupons often won’t get you the target yield, the equity component helps close the gap.
- Negotiate covenants and subordination agreements: Because mezzanine is subordinated, intercreditor or subordination agreements define payment priority, standstill rules, and remedies in default. Covenants are lighter than senior debt but still limit leverage, cap distributions, and restrict new borrowing.
- Close and fund: A typical mezzanine transaction takes 6–10 weeks from agreement to funding. Documentation includes the loan agreement, warrants, intercreditor agreements, and legal opinions. Closing fees usually run 1–3%, plus ongoing monitoring/administrative fees.
Covenants
Covenants are conditions written into loan agreements that set rules for the borrower’s financial health or business activities, helping lenders manage credit risk. They can include limits on leverage, minimum cash flow requirements, or restrictions on dividends and new debt. In mezzanine financing, covenants are usually lighter than those in senior debt but still protect lenders from excessive risk.
Typical terms, rates, and covenants of mezzanine loans
Most mezzanine deals follow predictable patterns: mid-teen blended returns, lighter covenants than senior debt, and maturities of 5–7 years with bullet repayment.
Interest structures
Mezzanine lenders balance liquidity needs with return goals by mixing cash and PIK interest. Hybrid examples include 8% cash plus 6% PIK in the early years, stepping to 12% cash later as performance improves.
Payment-in-kind (PIK) interest
PIK interest is a form of non-cash interest where you add the amount owed to the loan principal instead of paying in cash. It defers cash outflows in the short term but compounds over time, increasing your effective cost of capital.
Equity kickers
Warrants or convertibles provide lenders with upside potential. Warrant coverage typically ranges from 5–15% of fully diluted equity, with negotiated caps and protections to limit dilution.
Maturity and pre-payment
Loans generally mature in 5–7 years, repaid in a single bullet payment. Call protection discourages early repayment, often structured as non-call for 1 year, followed by 3–2–1% declining premiums. Borrowers usually gain redemption rights after this period, while lenders may hold put rights triggered by a change of control or covenant breach.
Bullet repayment
Bullet repayment is a loan payment structure where the borrower pays only interest during the term, and repays the full principal in one lump sum at maturity. It reduces near-term cash outflows but creates a large payment obligation at the end of the loan.
Pros and cons of mezzanine finance
Mezzanine financing balances flexibility and speed against higher cost and subordination risks. Understanding both sides helps you make informed decisions about whether it fits your situation.
Advantages: Limited dilution and flexible amortization
- Preserves ownership compared to issuing new equity, often limiting dilution to around 10% from warrants vs. 10–30% in an equity raise, depending on your funding round
- Flexible amortization schedules, often interest-only with PIK options, help conserve cash for operations and growth investments
- Expands available capital beyond what senior lenders will provide, supporting acquisitions, buyouts, or growth projects
- Typically closes in 6–10 weeks, faster than equity processes and with fewer governance concessions like board seats or veto rights
Disadvantages: Higher cost and subordination risk
- Higher cost than senior debt, with all-in interest of 12–20% vs. 6–11% for bank loans
- Can dilute ownership, even if less than issuing straight equity
- Exposes borrowers to payment blocks if senior covenants are breached, and may require curing senior defaults before mezzanine payments resume
- Adds covenants, reporting requirements, and intercreditor constraints that reduce flexibility with senior lenders
When to use mezzanine debt vs. equity
Mezzanine financing is best suited for companies with stable or improving cash flows that want to minimize dilution while funding major initiatives. Equity financing is a better fit when leverage is already high, cash flow is uncertain, or patient capital is required.
Growth capital and acquisitions
These fund organic expansion, product launches, or geographic rollouts. PIK structures can ease near-term cash burdens, while mezzanine also bridges the gap when banks won’t extend enough leverage to cover a full purchase price.
Shareholder buyouts
Shareholder buyouts support management buyouts or private equity deals by reducing the equity contribution required. This structure helps sponsors increase returns while allowing owners to preserve control.
Recapitalizations
These provide liquidity through dividend recaps or buyouts of passive investors without requiring a full company sale.
Who provides mezzanine debt funds and why
Mezzanine lenders target risk-adjusted returns in the mid-teens to low twenties, balancing contractual interest payments with equity upside potential. They fill a market need between conservative senior lenders and return-seeking equity investors.
Specialty mezzanine funds
Dedicated funds focus exclusively on middle-market mezzanine investments, typically targeting companies with $10–100 million in EBITDA. They bring deep expertise in structuring flexible terms and often provide value beyond capital through board observation rights and strategic guidance.
These funds understand the subordinated position's risks and price accordingly. They’ll work with you to structure terms that meet your cash flow constraints while targeting improved financial performance over time.
Private equity groups and family offices
PE firms often provide structured capital from affiliated credit funds to support portfolio company growth or new platform acquisitions. They understand equity value creation and structure mezzanine to align incentives while protecting downside.
Family offices participate in mezzanine lending for yield plus upside, often with longer investment horizons and more flexible underwriting than institutional funds. They might accept lower returns for the right relationship or strategic opportunity.
5 steps to secure funding from mezzanine lenders
A disciplined process improves terms, certainty, and speed to close. These five steps position you for success with mezzanine lenders.
1. Prepare audited financials and projections
Be prepared to provide 3 years of audited financials plus trailing 12 months (TTM) results. Build 3- to 5-year projections with revenue drivers, margin assumptions, capital expenditure plans, and working capital needs. Include KPI dashboards such as customer concentration, retention, and unit economics, supported by management bios and track records.
2. Build a capital stack presentation
Show your current and pro forma capital structure with detailed sources and uses of funds. Calculate leverage and coverage ratios before and after the mezzanine financing to demonstrate prudent levels. Articulate how the proceeds will be used, whether acquisitions, growth, working capital, or refinancing, and outline your growth plan, risks, and expected exit or refinancing path.
3. Run a competitive mezz fund process
Approach several reputable mezzanine funds at once to create competition. Share a consistent data room and timeline, requesting initial indications of interest (IOIs) within two to three weeks. Short-list two or three funds for diligence and final term sheets, using the competition to improve pricing, covenants, and flexibility.
4. Evaluate term sheets holistically
Compare more than just the coupon rate. Assess all fees, closing, commitment, and exit, as well as any original issue discount (OID). Review PIK terms, call protection, and prepayment penalties that affect refinancing flexibility. Model dilution from equity kickers, and weigh covenant packages, reporting requirements, and intercreditor provisions that could limit autonomy.
5. Integrate mezz reporting into your ERP
Set up covenant compliance calendars with alerts for testing dates and required submissions. Configure your accounting system to handle cash and PIK accruals correctly and automate fee amortization. Track warrant values with appropriate models and maintain dashboards for leverage, coverage, and liquidity to avoid covenant surprises and maintain lender confidence.
Tracking mezzanine interest and warrants in your finance stack
Effective tracking prevents compliance issues and surprises at board or lender meetings. Your accounting systems need configuration to handle the complexity of mezzanine instruments.
Automating accruals with accounting software
Configure separate instruments in your accounting software for cash-pay and PIK tranches to calculate compounding correctly. Set up automatic journal entries for monthly or quarterly interest accruals, ensuring PIK interest adds to principal for proper compounding.
Amortize fees and original issue discount using the effective interest method, spreading the cost over the loan's life rather than recognizing it upfront. Maintain warrant valuations using Black-Scholes or other appropriate models, updating each reporting period based on your company's value and volatility.
What is the Black-Scholes model?
The Black-Scholes model is a mathematical formula used to estimate the fair value of options and warrants. It considers variables such as the current stock price, the strike price, the time to expiration, expected volatility, and the risk-free interest rate.
In mezzanine financing, you’d use Black-Scholes to value warrants granted to lenders. This helps ensure that financial reporting reflects the potential dilution from equity kickers and that warrants are recorded accurately on the balance sheet.
Monitoring warrant dilution scenarios
Build cap table models showing full, partial, and cashless warrant exercise scenarios. Include conversion triggers and change-of-control provisions that might accelerate vesting or force exercise.
Model the impact on fully diluted ownership percentages and earnings per share under various exit valuations. Present these scenarios to management and the board quarterly, ensuring everyone understands the potential dilution as your company's value grows.
How Ramp helps you keep costs under control
Managing cash outflows becomes critical when servicing mezzanine debt with its higher interest rates and multiple payment streams. Ramp automates expense tracking, bill pay, and vendor management to help you maintain the cash flow visibility and control you need.
You can improve cash visibility to forecast interest and fee payments accurately, ensuring you never miss a payment or breach a covenant due to poor planning. Enforce spend controls across your organization to preserve liquidity and maintain covenant headroom.
Explore how Ramp can support your financing operations with our interactive demo.
FAQs
Because they are unsecured, high-risk debt vehicles, traditional banks and financial institutions are not known to provide mezzanine loans. Businesses seeking mezzanine financing will need to work with a specialized fund or non-bank lender.
Yes, borrowers often refinance mezzanine loans with senior or unitranche debt as EBITDA improves. Review call protection carefully, since make-whole provisions or prepayment penalties may apply. Refinancing should only proceed if projected interest savings exceed costs.
Ramp’s underwriting tools can help businesses secure a line of credit with a more favorable limit to achieve their goals. By leveraging data from top payment platforms, high-growth businesses and e-commerce companies can be evaluated on the merit of their performance, not the outdated requirements of traditional credit institutions.
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