Mezzanine finance is interesting and is starting to gain recognition and becoming famous. It is a hybrid of debt and equity financing. It can be useful for large projects, management buyouts, or growing businesses. Hence, a relatively complex form of business loan because it covers a range of complex funding scenarios.
If your business is looking to raise funds, there are two primary routes: debt, where you borrow money using a business loan; and equity, where you sell a share of your business in return for cash.
Mezzanine financing has rooted equity instruments, often known as warrants. It will increase the value of subordinated debt and allows better flexibility when dealing with bondholders. Mezzanine financing interrelates to acquisitions and buyouts.
The term “Mezzanine finance” is taken from where the credit platform sits in the middle between debt and equity finance. It is a sophisticated form of business credit. However, it can be useful in a few different situations, especially when a business needs to consider a third option to be used alongside a standard loan, equity fundraising, or both.
Let’s look at Debt, Equity versus Mezzanine financing
Debt, equity, and mezzanine finance are the three broad categories of business funding.
Debt financing is the technical term used to describe most borrowing. Whether the credit is a business loan, invoice finance, or a commercial mortgage, all are called Debt Finance. The specifics may vary, but the concept is that the business is taking on debt. The lender will give you cash in return for regular repayment that adds up to the principal amount borrowed and interest. Therefore, in debt finance, the lender has entirely the knowledge of how much they will profit in a given timeline.
Meanwhile, Equity fundraising is selling shares in your business to investors. The new stakeholders will benefit from any growth in your company as well as suffering if losses happen. The percentage of the market they own can fluctuate in value depending on how your company performs. Accordingly, it has a high risk to manage as part of a longer-term strategy for capitalists and private investors.
Mezzanine is the third option. The procedure varies between lenders, but the overall idea is that it’s a combination of some of the risk and reward of equity investment — a combination of concepts with the more predictable middle-term income of a loan.
The standard agreement in this platform is a loan that ‘converts’ to an equity share after a set timeframe elapses. It can also be the lender’s discretion, which means if things go well, the business can gain back the money. However, if the company could not pull back, the lender can recover costs through the shares in the company that increase in value.
How does Mezzanine Financing Work?
Mezzanine financing channels the gap between debt and equity financing. It is one of the highest-risk forms of debt. However, it offers some of the highest returns when compared to other debt types that often rates between 12% and 20% per annum.
Most business today is frequently seeking mezzanine financing to support specific growth projects or purchases. The familiar and interested providers of mezzanine finance are long-term investors that will benefit the long-term operation of the business.
With this, it makes the company to easily acquire other types of financing since traditional creditors generally favor if the company has long-term investors.
Common characteristics in the structuring of mezzanine loans, such as:
- These loans are subsidiary to an older standing debt, which becomes a priority to be paid.
- Unlike standard bank loans, mezzanine loans will demand a higher return than senior debt and are frequently unsecured.
- No principal amortization exists.
- The type of security is less dilutive than common equity. It makes part of the return on a mezzanine loan is fixed.
Do you know that investors like mezzanine debt?
Investors look at Mezzanine finance as an advantage towards investment growth.
- The small slice of ownership and warrants will entitle an investor to buy equity in the company. If huge success happens, there will be multiple potential profits that are more than the amount borrowed.
- Mezzanine financing can generate a return that is steady with the equity rather than the amount of debt.
- Mezzanine investors take risks just like equity investors. However, they get the benefit of having contracted interest payments each month, quarter, or year.
Advantages and disadvantages
For a company considering mezzanine financing, it is prudent to weigh the pros and cons to decide whether mezzanine is fit for the business.
- Often, it results in existing owner retaining majority control of the company, controlling the board, and management
- Mezzanine financing flexible compared to traditional bank loans.
- Less costly and less dilutive than a direct equity issuance
- Company will have an alternative capital resource to debt financing and equity financing
- Mezzanine supports long-term growth with interest only for up to seven or eight years and no amortization
- There are fewer control type provisions than typical minority private equity
- Mezzanine financing is costly than debt financing
- Mezzanine financing can still involve some equity dilution. Usually, these are in the form warrants of some structures
- Terms for a mezzanine financing include financial bonds and creditor rights
- Often, there is a prepayment penalty for a period following the issuance