How Does A Mezzanine Debt Work?
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.