Mezzanine Financing: Leveraging Ownership and Equity Interest to Secure Funding for Your Business Goals
If you’ve never heard of mezzanine financing, or are looking to figure out this popular financial solution before seeking a lender yourself, this guide covers everything you need to know.
Let’s get started…
What is Mezzanine Financing?
Mezzanine financing is a hybrid debt-equity solution that sits between secured senior debt and equity. In most situations, these agreements are secured based on the ability to repay the debt, generally through free cash flow, and not secured by assets like hard money loans or bridge financing. Lenders might also include a warrant on your mezzanine loan commercial real estate to convert security to ownership or equity interest if you default.
Typically, repayment for mezzanine financing falls behind senior banks. Lenders account for this increased risk through higher fees when compared to senior debt. In most cases, rates range between 12 and 20%.
However, since mezzanine debt comes before equity holders in the payment structuring, many senior banks view it as equity. This creates unique benefits you won’t find with other types of structured financing or hard money solutions.
How is Mezzanine Financing Used?
Mezzanine financing is often used for expansions and acquisitions.
By enabling you to reduce your private equity investment, you can see a higher return on your equity, drive growth and, hopefully, roll the mezzanine financing into a future round of senior financing for lowered rates.
Terms for financing tend to run longer than other structured financing solutions. On average, terms vary between 4 and 8 years. Though most include options for early exits and flexible repayment conditions.
What’s Needed for Mezzanine Financing Approval?
Two of the most critical conditions for mezzanine approval is free cash flow and a solid record of success in similar ventures and investment projects.
In many cases, mezzanine financing is approved with little due diligence. Therefore, holding a strong record or proven product, a comprehensive plan for repayment and sound financial estimates goes a long way toward approval.
Most mezzanine debt commercial real estate lenders will require a warrant for either ownership stake, preferred stock, payable in kind interest or equity in the property or business. They might even suggest for a mix of each.
Lenders might also require restrictive covenants that help to ensure that they receive a return for their risk.
Mezzanine Financing in Action
As a structured financing solution, mezzanine financing can take many forms.
Many lenders look for returns of 20% or higher. However, in most cases, lenders and borrowers work together to create an agreement favorable to both sides without the borrower bearing the full interest.
To accomplish this, lenders arrange a combination of interest, payable in kind interest, ownership stakes and preferred stock options.
As a basic example of mezzanine financing in action, let’s create a hypothetical business—Fidget-o-Rama. They’re now clearing $200,000 per year in profits. It’s currently for sale in your area for $1-million.
You don’t have the capital to purchase it outright, so you find a senior lender to help. Considering the various mezzanine financing Cary NC options, they offer to cover $600,000 of the cost at 8% interest, leaving you to kick in $400,000.
If you contributed the full amount, you’d pay $48,000 a year in interest to your senior lender, leaving you with $152,000 in profit before taxes. Assuming standard tax rates of 35% per year, this leaves you with $98,800 per year—or a return on 24.7% on your $400,000 investment.
Now let’s add a mezzanine lender into the mix…
You’ve secured $600,000 toward the business at 8% from a senior lender. However, a mezzanine lender is prepared to put up an added $200,000 at 15%. This leaves your capital investment at only $200,000.
You now pay $48,000 in interest to the senior lender and $30,000 to the mezzanine lender. This brings your pretax income down to $122,000. After taxes, you’re looking at $79,300 income for the year.
While the income itself is lower, so is your initial investment. With only $200,000 invested, you’re now making a 39.7% return!
Of course, this is a basic example. Many mezzanine lenders don’t work on an interest-only basis and there’s also the administrative fees for the loan due at signing.
In most cases, the interest covered is composed of a combination of regular cash payments and equity stakes or preferred stock options.
Some also use payable in kind interest—a concept that makes mezzanine financing more flexible. Instead of paying a scheduled interest payment, interest is rolled into the balance of the loan. It’s then paid off later—such as when the business is sold or senior financing secured for the mezzanine balance.
Pros and Cons of Mezzanine Financing
Although mezzanine financing can be a powerful tool for growing a business, expanding into new markets or funding leveraged buyouts and acquisitions, it’s not without its risks or drawbacks.
Here’s some aspects to consider before attempting to secure a mezzanine financing agreement.
Interest Rates are Much Higher than Traditional Senior Debt
If you can secure financing through a senior lender, there’s a good chance that overall costs will be lower than those on offer from a mezzanine lender. However, in most cases, mezzanine debt costs are still lower than equity costs and more flexible than other financial solutions.
Tax Deductions Might Offset Increased Interest Rates
However, as highlighted in the example above, increased rates might not result in increased costs. Especially if you have a solid plan for growth and see results from your efforts. If you are planning on refinancing or boosting your business or property in hopes of acquisition, this unique benefit makes mezzanine financing a powerful tool.
Mezzanine Financing is Often More Complicated than Traditional Financing
While flexibility is a great aspect of this type of financing, it’s also a weakness. Due to all the variables, mezzanine financing takes longer to arrange and approve than other forms of lending, such as hard money loans.
This makes this form of financing less than ideal when fast approval is needed.
As terms vary from lender to lender, understanding all terms and requirements associated with the structured solution is critical to fully understanding risks and costs.
Mezzanine Financing Works Best for Long-Term Investment
Most lenders prefer long-term relationships over quick turnover. After all, if your business sees enormous success and they have an equity or stock option, they’ll see greater returns—sometimes even more than the value of the financial agreement itself!
Yet, there is a fine balance. Due to the higher costs, keeping mezzanine financing in place for too long means paying higher fees than you might find if you refinanced the debt through a senior lender.
For this reason, it’s best to consider mezzanine financing as not just a financial solution, but a strategic decision. Understanding the full timeline, how and when you can repay the agreement and the actual cost of the financing arrangements is key.
Consider the Impact on Stock Value
Since it’s counted as equity, mezzanine financing has the potential to increase the value of stock held by existing shareholders. However, it’s also important to consider how mezzanine equity might dilute the value of stock.
Always Assess How Financing Might Impact Ownership Before Proceeding
While lenders often include warrants that allow them to claim a portion of ownership or equity upon default, most don’t want to exercise these options. However, as mezzanine lending is less regulated than traditional financial solutions, it’s important to be sure you understand exactly how the agreement might impact your control over the business should events take an unexpected turn.
Finding the Best Mezzanine Financing Lender
Most banks don’t offer mezzanine financing. Instead, you’ll need to work with private lenders or investment groups to find a structured solution that suits your business needs.
As you’ve seen in this guide, mezzanine financing is a complex solution. Despite this, most businesses find the complexity worth the benefits. However, as with any financial solution, who you work with has a major impact on your overall experience.
UT Financial Services, LLC, has more than 20 years of experience working with private investors, lenders and institutional capital to create financial solutions. We strive to create value for every client and want to help you reach your goals.
Get started and learn more about how mezzanine financing might help your business or investment project by calling today or filling out the form below. Our analysts will collect information about your situation and work to find the best options to help you succeed.
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