Mezzanine financing is a loan that combines traditional debt and equity. In addition, a lender has the right to convert the debt to equity or ownership of the company if the loan is not paid on time or in full. Mezzanine loans are typically subordinated to debt provided by banks and venture capital companies.
This type of financing is usually issued with little or no due diligence by the lender and no collateral from the borrower. As a result, the interest rates are aggressive, typically in the 20 to 30 percent range.
The typical borrower is an established business with a solid reputation, a successful product and an established track record. The company is usually looking to expand its operations with the help of outside funding.
Advantages for the Borrower
Mezzanine financing provides the borrower with the capital it needs to expand into new markets or acquire other businesses. As long as the firm continues to prosper, the lender will not interfere with the operation of the company.
The interest on debt is tax-deductible. Since the standard corporate tax rate is much higher, the after-tax rate becomes significantly lower.
Many mezzanine debts have flexible payment options. For example, the borrower may be allowed to pay interest by rolling that amount into the loan balance. This is helpful when cash flow is low.
If the company grows at a healthy rate, its value will increase too. Before long, the borrower will be able to refinance its mezzanine debt into a more reasonably-priced loan.
Advantages for the Investor
Many loans include a kicker clause, consisting of a piece of equity or options to purchase equity in the future. If the company is a success, these bonuses may exceed the original loan amount.
The return on mezzanine financing is significantly higher than traditional financial products. Given that U.S Treasury notes pay less than 2.3 percent annually, the profitability of these loans is attractive.
Mezzanine investors have contractually mandated interest payments on a regular basis. Equity investors are not entitled to recurring payments.
If business performance does not meet expectations, management could lose control of the business. This is especially true if the lender has a significant share of equity.
The debt agreement may have restrictions on financing and spending. The borrower may not be able to obtain additional financing or be able to restructure current debt. Also, the company may not be able to spend money in certain areas, such as specialized personnel.
Though mezzanine financing has risks, this loan might be a viable option if your company is poised for aggressive growth. Your due diligence will tell you if this is the right approach for your business.