Mezzanine equity is a type of financing that combines the characteristics of both debt and equity. It is most commonly used to fund the expansion or development of a business venture, and it provides capital to the borrower while retaining ownership control. Understanding how mezzanine equity works can help you make more informed decisions about raising capital for your company.
Finding mezzanine equity financing is difficult. Because a mezzanine transaction is risky for the lender, the rate of return on a mezzanine loan is high. However, the terms are frequently negotiable, and if your company performs well, mezzanine lenders are unlikely to interfere with management decisions.
What exactly is mezzanine equity?
Mezzanine equity is a type of financing that combines subordinated debt with additional equity features. This can include stock ownership, convertible debt, warrants, and options. For taking on more risk than other types of lending, the lender receives a relatively high rate of return. Lenders can bridge the gap between traditional borrowing and venture capital funding by providing mezzanine financing. Mezzanine lending is also in the middle, possessing both loan and equity characteristics. You make regular payments on the debt, just like a loan, but if you default, the lender converts the debt into mezzanine shares in your company. As part of the repayment, some mezzanine equity deals give the lender a stake in the company over time. In a third way, mezzanine falls in the middle. Some businesses use a mezzanine loan to bridge the gap between the initial mix of venture capital investors and loans and the subsequent public offering.
What Is Mezzanine Equity and How Does It Work?
Mezzanine equity financing is typically divided into two components: debt and equity. The debt portion is subordinate to the company's other debt and thus carries a higher risk than traditional borrowing. The equity portion is typically represented by warrants, options, or convertible notes, which provide the company with additional resources in exchange for a stake in the company. Mezzanine loans are frequently structured as "pay if earned" agreements, which require payment only if predetermined performance goals are met. Because they have more control over repayment schemes, this allows companies to secure capital with less risk to lenders. A mezzanine equity loan is similar to any other type of financing in some ways. The mezzanine lender writes you a check, and you make periodic loan payments. However, the differences between this and traditional financing are significant. Interest rates are often as high as 15% to 20%, and sometimes even higher. Typically, the lender obtains a claim on your assets in one of two ways: either the loan converts to an equity stake if you default, or your loan payments include an ownership share in addition to cash. Mezzanine lenders are drawn to the deals because of the combination of regular interest and equity.
The benefits and drawbacks of mezzanine floors
Despite the high interest rate, mezzanine equity has some advantages over equity or traditional debt: It's less expensive than giving your investors a direct equity stake.
Companies that provide mezzanine equity are in it for the long haul, so there is less pressure to provide them with an immediate return on their investment. They might even be willing to give you some advice. Mezzanine lenders are willing to negotiate repayment terms. Mezzanine equity lenders are usually content to remain hands-off as long as your company performs well. Other sources of funding may not be as accommodating.
Aside from the high interest rate, it also has a disadvantage. Mezzanine equity transactions typically take several months to complete. To protect themselves, mezzanine lenders frequently require restrictive covenants. A typical example of such restrictions in mezzanine financing is that you cannot borrow any more money because those loans take precedence over the mezzanine deal.
Is Mezzanine Equity a Good Fit for Your Company?
Investing in mezzanine equity can be a great strategy for businesses seeking financing without incurring debt or diluting their equity. However, entrepreneurs must decide whether this type of financing is appropriate for their business plan and overall goals. Depending on the circumstances, it may not be the best option, and it is critical to weigh all of the potential benefits and risks associated with this type of financing before making a final decision.