Capital Stack: Senior Debt vs. Mezzanine vs. Equity

The capital stack ranks a company’s financing by who gets paid first: senior debt at the top, equity at the bottom, mezzanine in between. That priority drives the cost of every layer.
Senior debt is the cheapest capital but is secured, covenant-heavy, and usually backed by a personal guaranty; the lender perfects its priority with a UCC-1 under Article 9.
Mezzanine debt fills the gap above senior capacity, charging a higher rate plus warrants and sitting behind the senior lender, governed by a subordination agreement.
Equity never has to be repaid but dilutes ownership permanently, and raising it is a securities offering under Regulation D and Washington’s RCW 21.20.
Debt versus equity is also a tax decision: the IRS can recharacterize thin debt under IRC section 385, interest is capped under section 163(j), and C-corp equity can preserve QSBS under section 1202.

A company that has outgrown its bank line has a money problem and a structure problem. It needs more capital than the senior lender will extend, but the owner does not want to sell a quarter of the company to get it. The answer is usually not one source of money but a stack of them, each priced differently and each with its own claim on the business if things go wrong.

That stack has a name. The capital stack is the layered set of financing a company raises, ranked by who gets paid first. Senior debt sits at the top, equity sits at the bottom, and a middle layer of mezzanine or subordinated debt fills the gap between them. That ranking does real work: it sets the cost of each dollar, decides who controls the company, and determines who recovers anything in a downturn.

What the capital stack is

Think of the stack as a ladder of priority. In a bankruptcy or a forced sale, the company pays its senior secured lenders first, the mezzanine lenders next, and the equity holders only if anything is left. That order explains almost every other term. The higher you sit in the stack, the safer your money, so the less return you demand. The lower you sit, the more risk you carry, so the more you charge. Senior debt is cheap because it gets paid first. Equity is expensive because it gets paid last, if at all.

Most growing companies use all three layers over time, and they raise them in roughly that order: a bank line first, a mezzanine layer when the bank will not extend more, and an equity round when the balance sheet cannot carry additional debt.

Senior debt vs. mezzanine debt

Senior debt is the cheapest capital a closely held company can get, and it comes with the most paper. A term loan or revolving line of credit carries a loan agreement, a promissory note, a security agreement, and almost always a personal guaranty from the owner. The lender perfects its claim by filing a UCC-1 financing statement under Article 9 of Washington’s Uniform Commercial Code (RCW 62A.9A), which fixes its priority ahead of later creditors. In exchange for first position, the lender keeps tight financial covenants and a lien on the company’s assets.

Mezzanine debt sits one rung down. It carries a higher interest rate, often twelve to twenty percent, and usually comes with warrants that give the lender a slice of the equity upside. It is unsecured or holds only a second lien, and it gets paid after the senior lender. Companies reach for it when the senior lender will not lend more and the owner does not want to sell equity at the current valuation. The price of that flexibility is the higher coupon and the warrants, which are a form of dilution by another name.

Mezzanine vs. equity

Equity is the bottom of the stack and the most expensive money in it. It never has to be repaid, which is its great advantage to a company that cannot yet service more debt. But it gives away a permanent share of every future dollar the business earns or sells for, and usually a vote on major decisions. A company sells equity when it has growth ahead of it and little to pledge, the opposite of the profile a senior lender wants.

The line between the layers blurs in practice. Mezzanine warrants are a sliver of equity. Convertible notes and SAFEs are debt that turns into equity later. The work is in structuring each instrument so it does what the company intends and does not collide with the layers above and below it.

Here is how the three layers compare on the terms that decide the choice.

Dimension	Senior debt	Mezzanine / subordinated	Equity
Cost of capital	Lowest (prime plus a spread)	Higher (often 12–20% plus warrants)	Highest (a share of all future upside)
Repayment	Fixed, amortizing schedule	Interest-only, balloon, or PIK	None; returned only on exit or dividend
Ownership dilution	None	Minimal (warrant coverage)	Direct dilution of existing equity
Priority in a downturn	First; senior secured	Behind senior, ahead of equity	Last in line
Security	Liens on assets plus personal guaranty	Unsecured or second-lien	Unsecured; an equity stake
Typical covenants	Tight financial and negative covenants	Looser, incurrence-based	Board rights and protective provisions
Best for	Predictable cash flow and hard assets	A growth gap above senior capacity	Pre-profit growth with little to pledge

Raising equity is a securities offering

The part owners underestimate most is that selling equity means selling a security, and securities law applies whether the company is a startup or a fifty-year-old manufacturer. Most private raises rely on the safe harbors in SEC Regulation D, built on the statutory private-placement exemption in Securities Act section 4(a)(2) (15 U.S.C. 77d(a)(2)). Rule 506(b) allows an unlimited raise from accredited investors and up to thirty-five sophisticated others, but bars general solicitation. Rule 506(c) permits public solicitation but requires verifying that every investor is accredited. Both need a Form D filing within fifteen days of the first sale, and Washington’s blue-sky requirements under the Securities Act of Washington (RCW 21.20) apply on top.

Getting the exemption wrong is not a paperwork problem. An offering that blows its exemption can hand investors a rescission right, meaning they can demand their money back, which is the last thing a company wants hanging over its cap table when it goes to raise the next round.

The tax layer, and the documents that hold the stack together

Whether a dollar is debt or equity is also a tax question. Money an owner contributes as debt generates deductible interest and a clean repayment path; the same dollars as equity do neither. The IRS can recharacterize a purported loan as equity under IRC section 385 if it is not documented and serviced like real debt, and interest deductibility is capped for larger companies under section 163(j). For a C-corporation, structuring the equity raise to preserve Qualified Small Business Stock eligibility under IRC section 1202 can be worth more at exit than any single round’s terms.

The document that actually holds a multi-layer stack together is the intercreditor or subordination agreement. It spells out who gets paid first, who can enforce on a default, and what the junior lender can and cannot do while the senior debt is outstanding. These are heavily negotiated, and a subordination clause broader than the owner realized can freeze the mezzanine lender out entirely in a workout. For the Bellevue and Seattle companies we work with, getting the intercreditor terms right at the front end is what keeps the stack from fighting itself two years later.

How to choose

The right layer follows the company’s cash flow, its assets, and how much ownership the owner is willing to part with.

Predictable cash flow and hard assets to pledge: senior debt is the cheapest money and the first place to look. Read the guaranty and the covenants before signing, because that is where a routine loan becomes a personal-liability problem.
A growth gap above what the senior lender will extend, and no appetite to dilute at today’s valuation: a mezzanine or subordinated layer bridges it, at a higher coupon and some warrant dilution.
Pre-profit, growing fast, with little to pledge: equity is the honest answer, with the securities compliance that comes with it.

Most companies end up with some of each. The mistake is raising one layer at a time without planning for the next, which is how owners end up with senior covenants that block the mezzanine raise, or a mezzanine lender whose consent rights stall the equity round. The stack should be drafted as a whole, even when it is built one layer at a time.

Frequently asked questions

What is a capital stack?

The capital stack is the layered set of financing a company raises, ranked by who gets paid first. Senior debt is at the top, equity at the bottom, and mezzanine or subordinated debt in between. The ranking drives the cost, the control, and the risk of each layer.

What is the difference between senior debt and mezzanine debt?

Senior debt is secured, sits first in line for repayment, and is the cheapest capital, but it carries tight covenants and usually a personal guaranty. Mezzanine debt sits behind it, is unsecured or second-lien, and charges a higher rate plus warrants in exchange for taking more risk.

When should a company use mezzanine financing instead of equity?

When it needs more than the senior lender will extend but does not want to dilute ownership at the current valuation. Mezzanine costs more than bank debt but less than giving away equity, and the warrants are a smaller giveaway than a priced round.

Do I need a lawyer to raise equity?

Raising equity is a securities offering, even a private one. It has to fit an exemption such as Regulation D Rule 506(b) or 506(c), requires a Form D filing, and triggers Washington’s blue-sky rules under RCW 21.20. Getting the exemption wrong can give investors the right to rescind, so the structure is worth getting right before you take the money.

What is a subordination agreement?

It is the contract among a company’s lenders that ranks their claims: who gets paid first, who can enforce on a default, and what the junior lender can do while senior debt is outstanding. It is the document that makes a multi-layer capital stack hold together.

A capital raise crosses lending law, securities law, and tax at once, and the terms you sign now set what the next round has to live with. Our corporate finance attorneys in Bellevue and Seattle structure the whole stack, not one layer at a time. Talk to us before you sign the term sheet.

Teru Olsen is a Shareholder at Oseran Hahn and an experienced business advisor and litigator, with a practice that spans business litigation, employment, real estate disputes, insurance coverage, and creditor-debtor work.

Teru began practicing in the Seattle area in 2008, working in debtor-creditor matters, real estate law and litigation, employment, transactions and disputes for growing companies, insurance-policy litigation on both the insurer and policyholder sides, and general business advising for small-market companies. He has handled matters at both ends of the spectrum, from a dispute between neighbors to the representation of a Fortune 500 company in a federal jury trial, and the range has taught him to read a problem from several legal angles at once. Clients credit him with clear explanations of their options, the legal hurdles, the fee budget, and the realistic outcome.

He grew up in Kirkland and is a graduate of Santa Clara University (2005) and Seattle University School of Law (2008). He began his career at Ryan, Swanson & Cleveland, PLLC, where he became a partner in 2016, and joined Oseran Hahn in January 2018 as a Principal, entering the partnership a year later. He is admitted in the Washington state courts and before the U.S. District and Bankruptcy Courts for the Western District of Washington and the Ninth Circuit Court of Appeals.

Teru has been named to Washington Super Lawyers in 2025 and 2026, after earlier recognition on the Rising Stars list from 2014 to 2018. He is a member of the Washington State Bar, the King County Bar Association, and the Asian Bar Association of Washington, and he recently completed six years as a Trustee of the Washington State Bar Foundation. Away from work, he spends his time with his family of five and the family’s Black Lab, Filly.