Mezzanine financing is a unique business financing product that allows the lender to convert unpaid debt into equity should the business default on payments. These loans are often layered on top of conventional loans in a typical capital structure, hence how they got their name.
Mezzanine financing allows business owners to borrow a larger amount of capital than they would be able to get with a conventional loan. This type of loan tends to be used during the expansion phase of an established company, rather than as start-up or early-phase funding.
Read on to learn the pros and cons of mezzanine financing, how it compares to debt and equity financing, plus other funding options you may want to consider for your business.
What Is Mezzanine Financing?
Mezzanine financing is defined as a hybrid of equity and debt financing. While there are many different ways this type of funding can be structured, it often starts out as a small business loan then, should the business default on payments, the lender can turn the loan into an equity ownership in the business.
Mezzanine financing might be used by companies when they are unable to access the amount of funding they need for a large capital investment through traditional debt products.
Mezzanine financing is typically structured as subordinated debt, which means it falls below senior debt. It is also typically unsecured, meaning it is not backed up by a lien or any type of business asset. Should the borrowing company go bankrupt, senior debt holders get first dibs on any of a company’s assets. The subordinated debt lender would be next in priority.
Since the odds of getting repaid in the event of liquidation are lower, lenders generally see subordinated debt as riskier than senior debt. To compensate for this, they usually charge higher interest rates than senior debt lenders.
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How Does Mezzanine Financing Work?
There are a variety of arrangements available for mezzanine financing. In some cases, a lender/investor might get immediate equity in a business. Often, however, the lender/investor will acquire warrants for purchasing equity at a later date. For example, if the company can’t pay back the funding, the lender then gets a share of equity instead. In this way, equity in the business is used as security.
A key benefit of mezzanine financing is that the loan is usually treated as equity on the balance sheet. As a result, it does not count as debt in the calculation of the company’s debt-to-equity ratio. This can improve the firm’s leverage position and make it possible for them to borrow in other ways, such as through standard bank loans.
Mezzanine funding generally isn’t available to startups or young companies. To receive mezzanine financing, a business must typically have an established reputation, solid product offering, history of profitability, and realistic growth plans.
Once a business owner finishes an expansion or large project using the mezzanine financing, they can often refinance the loan with a more conventional (and, ideally, less expensive) long-term business loan.
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Mezzanine Financing Structure
Businesses looking to raise money have two basic options: debt (where you borrow money using a business loan) or equity (where you sell a share of your business in return for cash). Mezzanine financing can offer a sort of middle ground, since it is structured as a combination of debt and equity securities.
How mezzanine debt is structured often depends on the needs of the borrowing company. Common options include:
• Cash interest payments With this structure, the business makes a periodic cash payment based on a percentage of the outstanding balance of the mezzanine financing. The interest rate can either be fixed, variable, or a combination (such as fixed for a certain period, then variable).
• Payable in kind (PIK) Interest PIK is a periodic interest payment where the payment is added to the principal instead of being paid in cash. This structure can alleviate short-term strains on a company’s cash flow.
• Ownership interest Mezzanine capital can use a variety of instruments to convey ownership interest, including preferred equity, warrants, and conversion features (similar to a convertible bond).
Maturity
Mezzanine financing generally matures in five years or more. When mezzanine financing matures, the borrower may be expected to pay off the principal with one balloon payment.
Redemption
Certain events trigger an automatic redemption provision (also called a mandatory prepayment provision). Examples include: asset sales, change of control transactions, and major acquisitions. If any applicable event occurs, the debt must be repaid.
Transferability
Generally, the lender in mezzanine financing has the right to transfer the loan unless there are restrictions outlined in the original contract. For instance, an issuer may limit transfers to competitors or only allow the mezzanine debt and equity to transfer together.
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Pros and Cons of Mezzanine Financing
| Pros of Mezzanine Financing | Cons of Mezzanine Financing |
|---|---|
| Does not require collateral | Higher interest rate than conventional business loans |
| Negotiable loan terms | Usually not available to startups or young companies |
| Gives up less equity than equity financing | May include multiple warrants |
| Interest on the mezzanine debt is typically tax-deductible | Potential for dilution of equity and loss of company control |
Pros
Mezzanine debt can be attractive to business owners because it does not require any collateral. Companies that utilize mezzanine financing often already have their assets tied up with other senior debt. They might then use mezzanine financing to complete a company buyout or initiate a large-scale purchase.
Mezzanine financing also offers flexibility. Because there are numerous ways mezzanine debt can be structured, the loan terms are negotiable for both the borrower and the lender. In some ways, it can be thought of as a common sense loan, since both parties must agree to the terms and conditions for the deal to move forward.
Also, depending on the deal, many mezzanine financing contracts allow for interest-only payments in the beginning. This gives the borrowing company time to get the company buyout or large-scale project up and rolling. These interest payments are generally a tax-deductible business expense for the borrower.
Cons
Mezzanine financing generally comes with much higher interest rates than traditional business loans. Sometimes higher rates means the lender has lower borrower requirements, but this is not the case with mezzanine financing. Before loaning a large amount to a company, mezzanine lenders typically want to see a proven record of success.
Since the loans are unsecured, the lenders will often incorporate restrictive conditions on the borrowers, such as warrants, options of partial ownership, and/or the agreement not to take out additional loans.
Any owner who considers mezzanine financing also needs to keep in mind that conversion to equity is always a possibility. If that happens, it will result in dilution of ownership and some loss of company control. It can also trigger a negative reaction from shareholders.
Mezzanine Financing Example
Mezzanine debt is commonly used in leveraged buyouts. To illustrate how it works, let’s say company ABC is interested in buying company XYZ for $100 million using a loan. The lender, however, only wants to put up 80% of the value and offers ABC a loan of $80 million.
ABC can’t or doesn’t want to come up with $20 million of its own capital, so it looks for a mezzanine lender to finance $15 million. By doing this, ABC only has to invest $5 million of its own capital to buy XYZ. The lender, on the other hand, will be able to convert the debt to equity if certain requirements are met.
Using this method of financing leverages ABC’s potential return while minimizing the amount of capital it has to put up to make the acquisition.
Mezzanine Loans
The amount of money a company can borrow with a mezzanine loan will vary depending on the lender. Often, a mezzanine lender will offer 4 to 4.5 times a company’s EBITDA (earnings before interest, taxes, depreciation, and amortization). Few companies are able to produce assets valuable enough to secure a loan of this size, which is why mezzanine loans can shift to company equity if and when needed.
Comparing Mezzanine, Debt, and Equity Financing
| Debt Financing | Equity Financing | Mezzanine Financing | |
|---|---|---|---|
| Relationship of parties | Borrower/lender | Co-owners | Borrower/lender |
| Subordination | Senior to mezzanine debt | Subordinate to mezzanine debt | Subordinate to senior debt, senior to equity |
| Repayment obligation? | Yes | No | Yes |
| Collateral? | Yes | No | No |
| Interest | Low interest | No interest | High Interest |
| Tax treatment | Interest is tax-deductible | No tax advantages | Interest is tax-deductible |
Alternatives to Mezzanine Debt
Mezzanine financing isn’t the only way to get the capital you need for business growth or expansion. There are many kinds of business loans on the market that may fit your company’s funding needs. Here are some to consider.
Business Term Loan
Business term loans provide you with a lump sum of capital – anywhere from $2,000 to $5 million – that you pay back (plus interest) on a fixed schedule over the loan’s term. Collateral, such as equipment or real estate, is often required.
Banks tend to offer low rates on term loans but carry stricter requirements — such as a strong personal credit score and high annual revenue — and take longer to fund. Bank term loans typically have long repayment terms of up to 10 years.
Online lenders offer speed and convenience but often charge higher rates. They also tend to have looser qualifications than banks. In addition, you can often get short-term loans with repayment terms between three months and three years from online business lenders.
Equipment Financing
Equipment financing is a loan for purchasing machinery and equipment essential to running your business. You may be able to get an equipment loan equal to up to 100% of the value of the equipment you’re looking to purchase — depending on which finance company you use and your business’s qualifications.
Since the equipment you are purchasing serves as collateral for the loan, you don’t need to put any business assets on the line to secure an equipment loan.
There are equipment finance companies that focus solely on this type of small business loan. But you can also get an equipment loan from lenders such as the U.S. Small Business Administration (SBA), banks, and other lenders.
Business Line of Credit
If you’re looking for a short-term, flexible form of financing, a business line of credit may be worth exploring. A credit line allows you to withdraw funds as needed up to a predetermined amount and only pay interest on the money you withdraw. Once you repay the funds you’ve borrowed, you can continue to draw on the line.
This type of financing is typically offered as unsecured debt, so you don’t need to provide collateral. Many unsecured lines of credit come with a variable interest rate and offer amounts ranging from $10,000 to $100,000.
To get a credit line larger than $100,000, you may need to secure it with a blanket lien on your assets or a certificate of deposit.
The Takeaway
Mezzanine financing can provide a company with its capital needs without putting its assets at risk. However, should the company default on payments, the lender may be able to convert the loan into equity, which will dilute ownership of the business.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
Why use mezzanine financing?
Mezzanine financing is a hybrid of debt and equity financing that allows business owners to borrow a larger amount of capital than they could get with a conventional loan.
What are some examples of mezzanine financing?
A common example of mezzanine financing is when a private equity firm wants to buy a company and the bank only wants to lend them 80% of the cost. Instead of having to put up the remaining 20%, the private equity firm might find a mezzanine lender to invest some or most of the rest. The mezzanine lender would be able to convert the debt to equity if certain requirements are met.
What form of mezzanine financing is most common?
The most common structure of mezzanine financing is unsecured subordinated debt (or sub-debt). Sub-debt falls directly below senior debt in the event of a liquidation.
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