What is Mezzanine Financing?
Mezzanine financing is a type of growth financing that is commonly seen in real estate development, acquisitions, and business expansions. It can be defined as a business funding that blends equity and debt.
It’s common for mezzanine financing to be used by profitable companies who can’t borrow more money in a traditional way but still require capital. In mezzanine financing, the lender might own a part in the business if it’s unable to pay back the money, but equity conversation is contractually structured instead of only being caused by a failure to pay.
Read the rest of this article to learn more about mezzanine financing and how it works.
How Does Mezzanine Financing Assist Parties Involved?
Both companies and investors can gain benefits from mezzanine financing.
- Companies use mezzanine financing to secure funds with flexible repayment terms. These are usually chosen based on their cash flow.
- Investors can take advantage of higher returns compared to traditional debt financing.
General benefits of mezzanine financing include:
- Ownership perks. Mezzanine financing causes less dilution than common equity.
- Long-term growth potential. As a result of its extended repayment terms, companies can follow through on their growth strategies.
- Supplementation. If prioritized debt in the company isn’t enough for capital needs, mezzanine financing provides another layer of money to fund what’s required.
What are the Cons or Risks of Mezzanine Financing?
Potential drawbacks or risks involved with mezzanine financing include higher interest rates when compared to traditional loans. Before a large amount is allocated to a company, lenders will want to view the company’s proven record of success to make the financing sound.
Here are other potential cons:
- The loans are unsecured. This means that the lender will usually include restrictive conditions, such as warrants.
- Conversion to equity possibility. This can result in ownership dilution and loss of control in the company, which could make shareholders have a negative reaction.
What Do Lenders Look for When Evaluating Companies?
A lender will typically look for the following:
- Consistent or growing cash flow profile.
- Strong and capable management teams.
- Cash flow to support principal payments (payments that lower original amounts borrowed on a loan) and interest.
- Enterprise value that’s larger than the debt level.
What are the Key Terms in Mezzanine Financing?
Mezzanine financing has a range of terms you’ll encounter. These include the following:
- Higher returns. Mezzanine financing provides higher returns than what you’ll get from traditional loans. The reason? It comes with a higher risk.
- Debt. Mezzanine financing usually takes the form of subordinated, unsecured debt. The debt could be in loan or debt security forms.
- Equity participation. Investors might want to enhance their returns by negotiating for equity participation along with their debt investments.
- Documentation. Mezzanine investment documents usually include an indenture or loan agreement (if mezzanine debt applies) or a certificate of designations (in the case of preferred stock).
- Maturity. It’s typical for mezzanine financing to mature within five or more years. When maturity is reached, the borrower can pay off the principal with a balloon payment.
How is Mezzanine Financing Structured?
Mezzanine financing is typically structured as a subordinated debt or preferred equity.
While a lender or investor might receive equity in a business immediately, it's more common for them to gain warrants for buying equity on a future date. This is common if the company can’t repay the funding. In that case, the lender will receive a share of equity instead.
After the loan term, mezzanine financing has what’s known as “bullet maturity.” This means that the amount is repaid after the loan term comes to an end.
Common structures for mezzanine financing include the following:
- Cash interest payments. How this works is that businesses make a payment in cash that’s based on a percentage of the outstanding balance. Fixed, variable or combination interest rates can apply.
- Payable in kind (PIK). The payment is added to the principal payment, not paid in cash. It’s used to relieve cash flow problems during times of financial strain.
- Ownership interest. Mezzanine financing makes use of various vehicles to convey ownership interest. This includes preferred equity.
How is Mezzanine Capital Used?
There are various instances when mezzanine financing is used:
- Growth capital. Mezzanine financing is used for growth capital to boost a company’s growth trajectory. For example, the money can be used for sales and marketing.
- Acquisition financing. Acquisitions give companies access to products and customers to enable them to enter new markets.
- Leveraged buyouts. Mezzanine debt can reduce how much equity is invested from people’s own pockets.
- Management buyouts. During a buyout, the company’s management gains control of the business from a parent company or investors.
- Shareholder buyouts. If a company wants to buy shares from a party, such as a passive investor, they will use mezzanine debt to replace equity.
- Refinancing. Mezzanine debt can be used to repay maturing debt.
What is the Difference Between Mezzanine Financing and Equity Finance?
Although mezzanine and equity finance can be useful for businesses, there are some important differences between them.
Mezzanine financing is usually structured as subordinated debt. It can include warrants or other equity features. Since it’s designed as debt, interest payments can be tax-deductible (provided the financing isn’t structured as preferred equity).
By comparison, equity financing is selling ownership in a company, such as in the form of stocks, in exchange for capital. Equity doesn’t require scheduled repayment but it can dilute ownership.
Do You Need a Lawyer for Mezzanine Financing?
Mezzanine financing can be complex, which is why working with a lawyer can be highly beneficial. A lawyer can help you in several ways.
- They’ll structure the deal so that terms are enforceable.
- They’ll tighten the covenants and restrict aggressive ones.
- They’ll ensure you stay compliant with all securities laws, such as if you’re dealing with warrants or convertible instruments.
- They’ll guide you on the best way to navigate the investment.
- They’ll clarify what the mezzanine financing entails so you understand all terms and can make the best decisions for your business.
If you need a lawyer, you can connect with one on ContractsCounsel, an online legal marketplace where clients can hire lawyers who have been vetted on the platform. They have the skills and experience to help you with mezzanine financing.
