Mezzanine financing is a blend of debt & equity. For example, when it comes to financing, money is prioritized like this:
Senior debt
Senior subordinated debt
Subordinated debt
Mezzanine debt
Owner’s equity
Mezzanine lenders are one of the last creditors to get paid if something ends up going wrong.
Mezzanine financing is a loan with terms that make the loan less important than various levels of senior debt as well as secured junior debt. However, typically the mezzanine lender will have a warrant that enables the security to be converted into equity at a pre-determined price per share if the loan isn’t paid in full or on time.
There are many variants. But the most common is that a portion of the money will be paid back as equity. Since it is unsecured and inferior, mezzanine financing is typically very expensive. Lenders usually look for 20%+ returns. Unless the market is full of money, mezzanine lenders are reluctant to lend without assurance that the company has decent cash flow, a good history of earnings/growth, and is respected in the industry.
Mezzanine financing is not a good option for start-up funding. Sources of this type of financing include banks, private investors, mutual funds, insurance companies, and pension funds.
Mechanics of Mezzanine Financing
Typically, there is some combo of lending by the lender and a provision of equity by the borrower involved in mezzanine lending. Ideally, the lender will hand over cash and get a warrant to convert the loan or at least a portion of it, to stock either when the lender chooses or in the case of default.
The mezzanine lender anticipates earning interest on the loan and quick appreciation of equity that they have acquired. Typically, mezzanine financing is used in acquisitions or leveraged buyouts in which all investors. Including the mezzanine lender, expect to cash out by taking the business public and refinancing it once the acquisition is complete. This allows the equity to be converted into cash with significant gains on the capital. If the deal fails, the mezzanine lender must expect to turn the company around by using the stock acquired by the warrant.
Borrowers turn to mezzanine lenders. After all, they are unable to acquire capital any other way because they don’t have financial health and they lack collateral. The cost is high, but they are betting on repaying the loan without giving up too much control.
Advantages & Disadvantages of Mezzanine Lending
Below, we’ll look at the advantages and disadvantages of mezzanine lending.
Advantages
Borrower rarely loses control of their company or direction. As long as the company continues to grow/prosper, the mezzanine lender is unlikely to interfere.
Flexibility in shaping rules of borrowing and the amortization schedules, especially involving conditions of repayment.
Mezzanine lenders tend to be long-term investors instead of those looking to make a quick score.
Lenders often are willing to offer strategic assistance.
Stock held by existing stockholders increases in value- through the mezzanine equity dilutes the value.
Provides owners with the capital needed to acquire another business or expand into another area.
Disadvantages
This may result in a loss of control over the business. Especially if projections don’t work out as expected or if the equity is high enough to grant the lender a larger share.
Most mezzanine lenders insist on restrictive covenants. Including requirements that the borrower cannot borrow more money, refinance senior debt with traditional loans, or create additional security interests in the assets of the business. May also force the borrower to meet certain ratios with their finances- for example, cash flow to equity.
Borrowers may be forced to accept restrictions related to how they spend their money in certain areas, such as the compensation of important personnel. They may be forced to take a pay cut and/or limit payouts of dividends.
More expensive than traditional or senior debt agreements.
Can be a long, tedious process- usually takes at least three months to set up and six to complete.
Conclusion
Mezzanine financing is not always the best option when you need funding. However, it can help if it’s one of your only options. Contact Achieve Capital Advisors to learn more about how this financial option can benefit you and your business.