Mezzanine finance is a hybrid of debt and equity financing that gives a lender the rights to convert to an ownership or equity interest in the company in case of default, after venture capital companies and other senior lenders are paid. For small or mid-sized companies that require a different level of flexibility with financing for growth and expansion, mezzanine financing provides an alternative to traditional financing outlets. Mezzanine financings can be structured in two ways either as debt or preferred stock.
To attract mezzanine financing, a company usually must demonstrate a track record in the industry with an established reputation and product, a history of profitability and a viable expansion plan for the business, such as through expansions, acquisitions or an initial public offering (IPO).
Typical interest rate for mezzanine finance is 12 to 20%, making it a high-risk, potentially high-return debt form. Mezzanine financing typically replaces part of the capital that equity investors would otherwise have to provide a company. For example, a private equity firm is purchasing a $200 million business. Senior lenders agree to provide $150 million. The private equity company secures mezzanine financing for $20 million and puts in $30 million of its own funds for the buyout. By using mezzanine financing, the purchasing company leverages its return while contributing less of its own capital.
Borrowers prefer mezzanine debt because the interest is tax-deductible. For example, with a standard corporate tax rate of 35%, a pretax interest rate of 20% is reduced to 13% after taxes. Also, mezzanine financing is more manageable than other debt structures because borrowers may figure their interest into the balance of the loan. If a borrower cannot make a scheduled interest payment, some or all of the interest may be deferred. This option is typically unavailable for other types of debt. In addition, quickly expanding companies grow in value and restructure mezzanine financing into one senior loan at a lower interest rate, saving on interest costs in the long term.
Mezzanine financing, commonly referred to as subordinated debt, is a combination of debt and equity funding provided by a specialty lender. A business owner can borrow a portion of the funds necessary for growth or expansion from the mezzanine financing firm, and the remaining funding is raised through the sale of company stock back to the same mezzanine lender. This type of financing is used among established business owners because it combines the advantages of conventional borrowing with the flexibility of equity financing under the direction of a single funding arrangement.
Most financing agreements that come from unconventional sources require the business owner to relinquish a degree of control over certain aspects of the business. Mezzanine lenders are no exception, as they often place a voting member on the board of directors or add a C-suite employee to the management team to have eyes on the ground. However, business owners who enter into a mezzanine finance arrangement do not give up control of daily operations of the business, nor are they required to make major changes to personnel. As long as the company continues to be profitable, a mezzanine lender does not take full control of the business away from the business owner.
Because mezzanine finance takes its position behind other business financing, business owners are afforded a greater degree of flexibility with the financing terms attached to this funding alternative. Subordinated debt positions do not generally require a pledge of collateral, allowing the business to access the capital necessary to fund growth and expansion without tying up valuable assets such as equipment or facilities that may be used as collateral for additional financing in the future. Additionally, mezzanine financing provides more flexibility in repayment terms as it relates to amortization, coupon rates and length of the loan. Mezzanine financing firms are more interested in the equity position obtained through the sale of company stock back to the firm than they are with stringent repayment of borrowed funds, and as such are willing to provide more favorable loan terms to the business.
Unlike conventional lenders that require repayment of borrowed funds over a short duration of two or three years, mezzanine financing firms provide companies an extended time frame to fulfill the terms of the financing agreement. Business owners that receive financing through a mezzanine lender can expect a long-term relationship with the firm due to the unique relationship established through the combination of debt and equity funding.
Mezzanine financing may result in lenders gaining equity in a business or warrants for purchasing equity at a later date. This may significantly increase an investor’s rate of return (ROR). In addition, mezzanine financing providers receive contractually obligated interest payments monthly, quarterly or annually. However, when securing mezzanine financing, owners sacrifice control and upside potential due to the loss of equity. Owners also pay more in interest the longer mezzanine financing is in place.
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