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Understanding Mezzanine Financing

Posted by Ryan M. Newburn | May 17, 2021 | 0 Comments

Business growth frequently requires capital, but not all forms of capital are created equally.  Many businesses seek financing to secure funding, and the corporate finance industry offers a plethora of options.  The Small Business Association reported that in 2019, small businesses in the United States had a combined outstanding debt of $644.5 billion.  For larger companies in the United States, corporate debt surpassed $10 trillion in 2020.  While it is often necessary to raise funds for business growth, it is also vitally important for businesses to ensure that they choose the best forms of financing for their particular circumstances.  Mezzanine financing is a unique option for accessing capital.  While mezzanine loans can create some financial advantages for businesses, they also carry some potential drawbacks.  If you are considering whether mezzanine financing is right for your situation, consider speaking with a knowledgeable attorney at Newburn Law to learn how we may be able to help you determine the best financing options for your business.

What Is Mezzanine Financing?

The term “mezzanine financing” might seem puzzling, but the concept is simple.  Much like a mezzanine sits between two floors of a building, mezzanine financing is wedged between senior debt and common equity in a business, and often blends features of debt and equity into a single loan package.

As the Treasury Department’s Office of the Comptroller of the Currency notes, mezzanine loans are often structured to incorporate both cash and preferred equity.  The cash portion of mezzanine financing is considered subordinated debt.  That means it is close to the end of the priority list of creditors if a business fails or files for bankruptcy.  Subordinated debt falls in line behind senior debt (usually traditional bank loans) and ahead of common equity.  Subordinated debt is usually considered riskier to investors, but the inclusion of preferred equity can also mean a significant return on investment if the company performs well.  Mezzanine financing may also include warrants or options for the creditor to buy equity in the company in the future.

Features of Mezzanine Financing

While each loan is unique, mezzanine loans often share some common features.  Here is a brief overview of the elements often found in mezzanine financing.

Subordinated debt.  As stated above, the cash portion of a mezzanine loan is considered subordinated or junior debt.  In addition to being lower on the priority list of repayment if the business becomes insolvent, mezzanine debt often carries a longer final maturity term, often up to seven or eight years.

Preferred equity.  Issuance of preferred equity is a common feature of mezzanine financing and includes a fixed-rate coupon or dividend.  It may include some participation rights in the business as well.

Options or warrants.  Terms of a mezzanine loan may include options or warrants for the creditor to purchase equity in the company at a later time.

No amortization.  Mezzanine loans typically do not include amortization, meaning that principal payments are not due until the loan matures.

Flexible options for interest payments.  Mezzanine financing often includes the option of payment-in-kind for scheduled interest payments.  This feature allows businesses to roll an interest payment into the balance of the loan, essentially deferring the interest payment for a period of time.

Businesses need to understand how mezzanine financing or any other form of capital impacts debt structure, profitability, and the balance sheet overall.  A knowledgeable attorney at Newburn Law can help you assess your options and provide guidance in choosing the right mode of financing for your business.

Uses For Mezzanine Financing

The unique structure of mezzanine financing makes it more suited for some situations than others.  Businesses often use mezzanine loans to raise capital beyond what senior lenders are inclined to extend or to preserve their future capacity to acquire senior debt while still raising capital to fund growth.  As these two scenarios demonstrate, mezzanine financing is generally a better fit for established companies rather than for start-ups or early-phase funding.

Mezzanine financing is often used to raise capital for:

  • Acquisitions
  • Management buyouts
  • Shareholder buyouts
  • Restructuring capital
  • Refinancing debt
  • Growing or expanding a business

Pros And Cons Of Mezzanine Financing

Like any form of debt, mezzanine financing has advantages and drawbacks.  While mezzanine loans can provide significant financial and strategic advantages, they are not right for every business or every situation.  Businesses should consider how the positive and negative consequences of mezzanine loans will impact their overall financial health and capacity for growth.  Here are a few common pros and cons of mezzanine financing.

Pros

  • Minimal dilution of equity in compared to equity financing
  • Current owners usually retain majority control of the business
  • Terms are generally more flexible than those of traditional bank loans
  • Serves as a capital resource beyond what a business can access through senior debt or equity alone
  • Often listed as equity on the balance sheet, allowing businesses to show lower levels of debt and potentially qualify for other forms of financing
  • Interest payments may be tax-deductible

Cons

  • Usually more costly than senior debt, with interest rates often ranging between 20% and 30%
  • Often includes a prepayment penalty for a period of time after issuance
  • May involve dilution of equity, though typically small
  • Terms may require shared control or special rights for mezzanine loan creditors

How An Attorney Can Help With Mezzanine Financing

Access to capital is crucial for business growth, and there are many options for corporate or small business financing.  Businesses must weigh the risks and benefits of each financial option, and find the best financing solutions for their unique situation.  Mezzanine financing offers unique advantages over senior debt and common equity but is not always the best option.  The decision to secure a business loan is a serious financial and legal matter, and business owners would be wise to seek legal guidance.  An attorney can assist by assessing a business's financial health, goals, and needs, analyzing financing options, and recommending a path forward.  If you are considering mezzanine financing for your business, consider speaking with a knowledgeable attorney at Newburn Law to understand how we may be able to help with your corporate finance needs.

About the Author

Ryan M. Newburn

Ryan Newburn is a business and legal expert trusted by Executive Teams and Boards of Directors to apply sound business principals to solve legal and financial problems. Ryan's practice focuses on mergers and acquisitions, financings, corporate formations and corporate governance in a broad range of industries including energy, distribution services, healthcare, medical devices, and technology. Leveraging his formal business training and years of practical experience, including as an executive at public and private companies, Ryan has advised hundreds of companies in dozens of industries of unique legal and financial issues.

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