Debt financing has always been a challenge to secure for smaller businesses without a good credit history, sufficient collateral, or a strong cash flow. More recently, this challenge has become all the more difficult. Banks and other lenders have become ever more hesitant to lend to unproven, seemingly risky businesses.
To circumvent this problem, small businesses have turned their attention elsewhere, in an effort to find alternative forms of financing. One such example is mezzanine financing. With this form of financing, businesses can obtain the necessary capital to fuel growth, funding expansions, necessary purchases, acquisitions, and so on.
To accommodate this recent interest in an alternative form of financing, lenders of all stripes have steadily begun to offer financing of this kind. This move effectively meets the demand, making this relatively novel form of financing viable. In this article, we will break down mezzanine financing. Explaining how it works, and how it might help you and your business.
What is mezzanine financing?
As implied by the name, mezzanine financing is a middle ground between the senior debt owed by a company and equity. Because of this middle ground status, it is often referred to as a subordinated or junior debt. This means that it plays second fiddle to senior debts, which must be paid first in the event a business defaults.
Unlike senior debts, which are usually secured by assets or tangible possessions, mezzanine financing is secured by the value of a business’s cash flow. As its intended use is to bridge the gap between existing debt and equity, mezzanine financing tends to be used in more unusual cases. Lending institutions are not likely to lend beyond a certain limit, making obtaining capital in extraordinary events, such as the global pandemic, almost an impossibility. With mezzanine financing, however, this becomes possible.
The structure of mezzanine financing
As mentioned earlier, businesses tend to use mezzanine financing when they need additional capital, but can’t or won’t secure finance through traditional means. For example, a business that requires capital in order to purchase property may look to mezzanine financing to avoid giving up equity. However, given it’s flexible nature, it can be refinanced at a later date. While this usually results in a senior loan, it provides the benefit of a reduced interest rate, making it an appealing option after a successful expansion.
Let’s take a practical example. Suppose a business requires £5 million in order to purchase much-needed property for expansion. The business secures £3 million from a bank, or another traditional form of finance, but is refused the remaining £2 million. This shortfall would ordinarily put a stop to any plans of expansion, but mezzanine financing can make up the rest. In this case, the mezzanine finance would be subordinate to the bank loan, which would be regarded as the senior loan. Although, as mentioned earlier, if this expansion produced favourable results, the business could consider refinancing this to better suit its needs.
Applications for mezzanine financing
Mezzanine financing has a plethora of practical applications. The long-term nature of this type of loan, alongside its ability to bridge gaps between existing debt and business equity, makes it a viable option to achieve a wide range of goals.
While useful for funding shareholder buyouts or optimising accounts, it is especially effective for facilitating growth. Funding expansion projects, be they property purchases, acquisitions, or buyouts, is a difficult task. They are costly endeavours, ones that often can’t be funded by traditional means alone.
Advantages of mezzanine financing
Mezzanine financing confers a number of benefits to a business that employs it. Firstly, as we’ve mentioned, it is a particularly flexible form of finance. One that can be adjusted at a later date if a business prefers. Doing so can provide further benefits, such as a lower interest rate or reduced amortisation. Alternatively, a business could opt to keep the loan as is. This will allow a business to raise capital for its needs, without having to sacrifice equity in order to achieve its goals. This is a significant benefit for any business, one that isn’t offered by many other forms of finance.
While typically more expensive than senior loans, mezzanine financing is considerably cheaper than other loans of a similar stripe. For example, a direct equity issuance. This makes it a good form of finance that complements senior loans.
Disadvantages of mezzanine financing
As with anything, this type of financing isn’t a purely positive means of raising capital. Chiefly amongst its disadvantages is the cost. It is notably more costly than senior loans, though this can be mitigated by refinancing the loan at a later date and taking advantage of lower interest rates. Moreover, despite the flexibility of mezzanine financing, such loans tend to come with financial covenants and creditor rights. They act as a layer of security for lenders, binding the borrower to adhere to the terms of the contract.
Depending on your lender, the terms of your mezzanine financing may include equity dilution. Where this occurs, it tends to be only a small amount. Though it could be a dealbreaker for you, depending on your situation. Lastly, if you intend to pay back your loan early, you will likely be subject to a prepayment penalty. This penalty is usually for a short period after the loan is issued. But again, the specifics depend on your lender.
Conclusion
Mezzanine financing can be an excellent form of finance for small businesses looking to grow. It allows businesses to bridge the gap between any outstanding debts and equity. Often being utilised to make up the shortfall for an expansion project. Additionally, it is quite flexible, allowing for adjustments to be made down the line should circumstances change.
However, mezzanine financing comes with its cons, most notably its price. For all its benefits, it can be an expensive option for small businesses. One they should consider carefully, especially if they aim to expand. This being said, mezzanine financing could be exactly what a business needs to expand at all. Making it a useful tool to keep close at hand.