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    How Does A Mezzanine Debt Work?

    Nathan J. Lee Profile
    Nathan J. Lee - 2020-10-12T21:00:00.000Z
    Mezzanine Debt

    You’ve heard about traditional lending and equity financing. Mezzanine debt is a type of borrowing that effectively combines the two. It’s a unique type of funding utilized by large corporations that need significant capital to invest in growth. Still, just like any kind of borrowing, it comes with its very own set of benefits and risks. 

    Read on to learn more about mezzanine debt warrants and other facets of this unique financing vehicle.

    What Is Mezzanine Debt?

    As previously stated, this type of financing is a cross between equity funding and debt financing. It differs from traditional financing in several ways.

    This lending product helps large companies raise capital for large-scale projects and cover the cost of acquiring other businesses. Startups rarely use this method of funding since obtaining equity financing, in general, is more challenging for them. By comparison, established enterprises entering a significant growth stage are ideal candidates.

    There are a few unique aspects that accompany this financing type. For instance, if the company defaults on the loan, the lender can convert mezzanine debt into equity when certain conditions have been met.

    How Does Mezzanine Debt Work?

    This type of debt is widely considered one of the riskiest forms of lending. For this reason, the cost of capital is significantly higher. For instance, interest rates can reach double-digits. There are also embedded instruments attached to it, known as warrants.

    A company often turns to this financing option when the capital required for growth exceeds the amount traditional lenders are willing to provide. 

    This lending product is usually unsecured, with either fixed or variable-rate interest. Although the interest rates are higher relative to traditional financing methods, the repayment terms are generally more flexible.

    Lenders typically prefer companies with an excellent track record alongside applicants that can demonstrate long-term profitability.

    What Is Equity Financing?

    Equity financing is the other partner in the mezzanine financing hybrid. This lending method involves trading a percentage of the equity in the business in exchange for the loan. For example, you might approach equity investors for $50,000 in exchange for 4% ownership in your company. 

    The investor benefits because they gain shares in the company, and you get the capital needed without taking on additional debt. Depending on the terms, equity funding can effectively meet short-term and long-term business objectives.

    Equity financing is less risky than traditional lending. If the business fails, you don’t face the same consequences since it isn’t a debt. On the other hand, it changes the dynamics of ownership. Outside investors now share control of the business. While you still may be the majority shareholder, investors might have different ideas about actualizing the company mission.

    Pros And Cons

    Mezzanine capital comes with its share of benefits and drawabcks for lenders and corporate borrowers alike.

    Pros

    • The interest is tax-deductible for borrowers
    • A company can access the total capital needed for expansion projects without redistributing significant equity
    • It’s more flexible. If the business doesn’t have the cash flow to make the scheduled interest payment, it can be deferred or capitalized
    • It’s usually listed as equity on financial statements, making it easier to qualify for other types of financing
    • For lenders, this option opens the door to purchasing equity or securing mezzanine warrants that can be exercised to buy equity later

    Cons

    • The hybrid financing includes equity, which means that the company might have to cede some control to lenders
    • If the loan goes into default, equity must be provided to mezzanine creditors
    • The longer it takes to repay this loan, the more it can potentially cost company owners
    • If the company is forced to file for bankruptcy, lenders can lose their entire investment
    • Moreover, secured and senior debt holders are prioritized for repayment if a default unfolds. Mezzanine lenders are second in line and might be left with nothing

    Mezzanine Example

    When seeking to define mezzanine debt, envision the partial floor between two floors in a building. This financing is the middle floor between equity and senior (secured) debt.

    This lending product is structured so that payment on the principal amount doesn’t happen until you’re near the end of the loan’s term. This is another reason that interest rates are much higher.

    This financing can work in many different combinations. Here’s one example to help bring the concept to life:

    • GDG LLC has an opportunity to acquire its largest competitor in the digital marketing services space. The acquisition will radically transform GDG’s standing in the global marketplace. The company needs capital that exceeds the amount any capital lending institution can provide
    • Finally, the company found a lender that was interested in helping the owners put together a deal. GDG received a total of $80 million, of which $60 million was mezzanine financing. Interest was set at 20% while concurrently granting the creditor equity warrants which can later be converted into an equity stake in the company depending on the outcome

    Bottom Line

    Mezzanine capital is more flexible than traditional lending, but the interest rates are substantially higher. For companies seeking a massive infusion of cash for capital expansion, this hybrid financing vehicle can be the best way to meet its objectives.

    However, the blending of debt and equity means that you might lose some control over your business in the process.