Growing mid-sized companies often spread themselves financially thin when trying to develop and expand. This is not necessarily bad, but when unfavorable situations arise, the company may not have the tools to deal with these difficulties. This is where mezzanine lending comes in. To handle short-term cash needs, there are often existing lines of credit with a bank. However, these lines of credit typically include strict loan covenants. These strict covenants provide the bank with security in the loan, but the covenant restrictions can tie the hands of the borrowing company given that the restrictions are in place to protect the bank’s designated collateral. When the credit line grows strained and funding equity is not an option, mezzanine loans may be a good option for a mid-sized growing company to continue to progress.
Mezzanine loans are a hybrid financial instrument. This hybrid nature allows lenders to make special concessions that still provide security for the borrowing company’s banks but also offer flexibility for the company. This article focuses on what a mezzanine loan is, who qualifies or benefits from these loans, some of the pros and cons associated with mezzanine loans, and other alternative financing options. To better understand what kind of analysis must be completed to determine an optimal combination of debt and equity for a borrower, see our article, Founder Control.
What is a Mezzanine Loan?
Mezzanine loans are hybrid instruments that have characteristics of both debt and equity. This hybrid nature allows the lenders to be flexible in balancing risks and rewards. The flexibility comes through the attributes of junior debt, possible warrants, and loan covenants.
When a substantial portion of the company is financed with debt, the debt holders often place many constraints upon the borrowing company. For example, the lender might only loan a percentage of the company’s outstanding accounts receivable (AR) balance, with the loan amount backed by a selected set of outstanding customer accounts. If operating cash flows are insufficient to make loan payments, then those payments come from the payments of the company’s customers. When calculating the allowable loan amount as a percentage of AR, the acceptable customers’ accounts would generally receive a pruning. For example, any customer with a past-due balance, or from a specific location, might be removed from the AR list to give the bank a set of solid receivables to serve as the collateral for the loan. If the borrowing company goes out of business, the secured debt holders are first in line to get access to the money from asset liquidation, and if a prudent loan amount is supported by a set of high-quality receivables, the lender would be able to receive a significant repayment of the loan. When the senior debt lenders have been paid in full, the other stakeholders, such as junior debt holders, would be able to lay claim to remaining assets. Due to the hierarchy of payment from asset liquidation, equity investors are in a riskier position. If the company runs into financial trouble, the investors might not get back any of the money they put into the company.
Debt and Equity Hybrid Characteristics of Mezzanine Loans
Mezzanine loans are often regarded as junior debt. This means that in asset liquidation, these lenders are next in line behind the banks and other secured lenders. The existence of mezzanine loans rarely causes problems for the borrowing company’s banks because the mezzanine lender has lower priority in case of liquidation and does not have claim on the collateral of secured loans. To encourage potential lenders to accept the riskiness of making a mezzanine loan, these mezzanine loans often include equity warrants of some sort. The inclusion of these warrants allows the mezzanine lender to have a potential stake in the borrowing company and to enjoy legal rights to future equity value if exercised. Warrants are options to purchase a certain number of shares, at a specific price, on a specified date. With a typical mezzanine loan for a small company, the warrants included in the package generally amount to 1%-5% of the ownership shares of equity.1 The warrants give the mezzanine lender the opportunity to heighten the potential return on the investment, without the receiving company giving up substantial amounts of equity. This allows the mezzanine loan to stay versatile and flexible. Warrants also motivate the lender to take more interest in the future profitability of the company. This generally promotes a more beneficial and open relationship between the entities.
Benefits for Debt-constrained Companies
Mezzanine loan contracts are usually written carefully to avoid infringing on existing loan covenants. Mid-sized companies often have many loan covenants to reduce lender risk of nonpayment. These loan covenant restrictions create constraints for the borrowing company in terms of subsequent financing. For example, a standard loan covenant restriction is a limitation on additional borrowing that is senior to existing loans. A mezzanine loan allows the borrowing company to get more money without breaking existing loan covenants or alienating existing lenders. Many mezzanine loans are unsecured which means they require no tangible loan collateral. Mezzanine loan contracts are also often written to make the borrowing in the form of “junior loans” that have secondary rights of collection upon asset liquidation, subordinate to senior debt lenders.
Another common feature of mezzanine loans is a creative payment structure. Normal loans involve the borrowing company paying for interest, as well as repaying the original loan balance, over the life of the loan. A common feature of mezzanine loans is interest-only payments. At the end of loan period, the borrowing company must pay back the entire original principal amount of the loan. This interest-only payment method is of value to the borrowing company because the loan’s periodic interest payments are smaller compared to a normal, fully amortizing loan. With smaller loan payments, the company doesn’t need to use scarce cash to make principal payments and can instead use that cash for growth. The benefit to the mezzanine lender of an interest-only loan is a higher interest rate.
What Kind of Organizations Benefit Most from a Mezzanine Loan?
There are multiple similarities among companies that benefit from mezzanine loans. Borrowing companies with consistent cash flows, mid-sized nature, reasonable previous debt, and an asset-light portfolio make the most of the benefits of a mezzanine loan.
Consistent cash flows are required because stable interest payments are vital to the mezzanine lender. There must be a safety net for the lender because although the high interest rates mean that these mezzanine loans can be profitable for the lender, those profits disappear if the borrowing company doesn’t pay.
Mezzanine loans tend to be used by mid-sized companies. Generally, companies receiving mezzanine loans range from $10 million to $100 million of EBITDA per year. This size allows for the mezzanine lender to make a reasonable profit from the loan as well as providing proof that the borrowing company can generate consistent income.
The amount of mezzanine debt used is specific to each company, but overall the lender must be confident that the borrowing company has enough cash flow to maintain payments on senior debt with sufficient cash flow left over to service the mezzanine loan.
The last general characteristic of a company that benefits greatly from mezzanine lending is the nature of the borrowing company’s assets. Companies that operate with few tangible assets have less attractive collateral and therefore less security to provide to lenders in the case of a default. Due to the interest-focused payments and the higher interest rate on risky mezzanine loans, mezzanine lenders care less about the collateral, which allow companies that have less tangible collateral to offer normal lenders a chance to have solid financing.
Pros and Cons for Borrowing
Mezzanine loans are a part of a growing market that allows for versatile lending. Mezzanine loans are a riskier form of financing compared to traditional bank loans and secured debts. Included below is a chart showing the pros and cons of a few of the characteristics of mezzanine loans.
Alternatives to Mezzanine Loans
For growing mid-sized companies, there are a couple other options to consider when searching for alternative financing. As companies are in funding rounds on the path to an IPO, it is difficult to manage cash flow as the growth tends to be volatile. When money is needed quickly before the next round, bridge loans present a convertible form of debt that allow a future investor the opportunity to contribute to the company sooner while providing financial benefits for the company. For more information, see our Bridge Loans article.
Another option in this vein is convertible preferred stock or convertible debt. These give a company flexibility in how they finance and reduce investor risk by giving the investor more control in the financial investment. To see more on this topic, see our Convertible Preferred Stock and Convertible Debt article.
Another example of debt financing when a company is stretched thin is revenue-based financing. This is optimal for companies that have a consistent stream of cash flow and are in a stable growth period. With revenue-based financing, the loan is repaid through a portion of future revenue. This allows a company to be more secure when not basing the loan on collateral. To read more on this, see our article on Revenue-Based Financing.
Mezzanine loans offer a unique way to finance your company. Because this kind of loan sits between common equity and senior debt, it allows a company more freedom in their borrowing. Due to flexibility provided by the hybrid aspect, the maneuverability in the lack of collateral, and the long-term nature of the financing, mezzanine loans offer a great financing option for many companies. It is important to weigh the advantages and disadvantages of this kind of financing as it tends to excel in specific scenarios. It is always important to project what could occur when taking out a long-term loan like this and to consider the options from other sources to best help your business to grow and develop.
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