Mezzanine Debt: A Smart Way to Raise Funds Without Losing Control

Introduction

Businesses need funds to grow, expand, or buy other companies. While bank loans (senior debt) are a common way to get money, they are not always enough. At the same time, raising funds by selling company shares (equity) can reduce the owner’s control over the business.

In such cases, mezzanine debt acts as a bridge between senior debt and equity. It provides additional funding without forcing the business owner to give up too much ownership. This type of loan is widely used in business expansions, management buyouts, and corporate acquisitions.

Let’s understand mezzanine debt in simple terms, how it works, its advantages, risks, and when it should be used.

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What is Mezzanine Debt?

Mezzanine debt is a special type of loan that is riskier than a bank loan but safer than investing in company shares. In simple words, if a company fails, the bank will get paid first, then mezzanine lenders, and finally, the shareholders (owners).

Because it is riskier than a normal bank loan, mezzanine debt has higher interest rates (10-20%) and often includes an equity option. This means the lender may also get a chance to buy shares in the company at a future date.

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Key Features of Mezzanine Debt

1. Sits Between Debt and Equity – If the company goes bankrupt, mezzanine lenders are paid after banks but before shareholders.
2. Higher Interest Rates – Since this loan is risky, lenders charge more interest compared to banks.
3. Equity Bonus for Lenders – Lenders may get share options in the company along with loan repayments.
4. Flexible Payment Options – Some lenders allow businesses to delay interest payments or pay in shares instead of cash.
5. Used for Business Growth – Many companies use mezzanine financing to expand, buy other companies, or fund new projects.

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How Does Mezzanine Debt Work?

Let’s say ABC Pvt Ltd, a company in India, wants to expand its business but needs ₹100 crore for the project. Here’s how they can arrange the money:

• Bank Loan (Senior Debt): ₹60 crore (provided by a bank)
• Company’s Own Investment (Equity): ₹20 crore (from the owner’s pocket)
• Mezzanine Debt: ₹20 crore (borrowed from a mezzanine lender)

In this case, the mezzanine debt fills the funding gap without making the business owner give up too much company ownership.

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Types of Mezzanine Financing

There are different ways mezzanine financing can be structured:

1. Subordinated Loans – A simple loan that has a higher risk than a bank loan but lower than equity.
2. Convertible Debt – The lender can convert the loan into company shares if needed.
3. Warrants & Equity Options – The lender gets the right to buy company shares at a fixed price later.
4. Payment-in-Kind (PIK) Loans – The company doesn’t pay cash interest immediately; instead, the interest is added to the loan amount.

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Advantages of Mezzanine Debt

For Businesses

✔ Less Dilution of Ownership – Unlike selling shares, mezzanine debt helps business owners keep control over the company.
✔ Additional Funding – It provides more money when banks are not willing to lend enough.
✔ Flexible Payments – Businesses can negotiate better repayment options, like paying interest later.
✔ Tax Benefits – Interest paid on mezzanine debt is usually tax-deductible, reducing company taxes.

For Investors

✔ Higher Returns – Lenders earn more interest compared to normal bank loans.
✔ Equity Upside – If the company performs well, lenders may gain additional profits from share options.
✔ Balanced Investment – It provides a mix of fixed-income (loan interest) and potential share price growth.

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Risks and Disadvantages of Mezzanine Debt

🔴 Higher Cost – The interest rate is higher than a normal bank loan.
🔴 More Financial Risk – The company must ensure it can repay the loan; otherwise, it may face financial problems.
🔴 Lender Influence – Some lenders may demand a say in company decisions.
🔴 Possibility of Losing Ownership – If the company cannot repay, lenders may convert the debt into shares, reducing the owner’s stake.

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When Should a Company Use Mezzanine Debt?

Mezzanine debt is best for businesses in the following situations:

📌 Business Expansion – When a company wants to grow without raising new equity.
📌 Acquisitions & Buyouts – When one company is buying another and needs additional funds.
📌 Debt Restructuring – When a company wants to replace old loans with better financing options.
📌 Bridging to an IPO – When a company plans to go public (IPO) but needs temporary funding.

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