Businesses sometimes need to secure additional capital, whether to expand operations or make a strategic acquisition. This often involves exploring alternative financing options and sources of working capital outside of traditional loans. Mezzanine financing, or a mezzanine loan, is one such option, and because it comes with its own unique structure and risk profile, it’s important to understand how its various features and obligations may or may not be advantageous for your business.
In this blog, we’ll tell you everything you should know about mezzanine financing, how it works, the pros and cons, where to find a mezzanine lender, and how to optimize business operations after receiving a loan.
What is mezzanine financing?
Mezzanine financing is a hybrid form of loan that combines debt and equity financing. When lenders provide a mezzanine loan, they reserve the right to convert outstanding debt to equity in the company if the borrower defaults. In most cases, mezzanine financing involves subordinated debt, and in terms of capital structure, the loan sits below senior debt and above common stock or equity.
Because mezzanine financing is considered a higher risk for lenders, they are likely to seek higher returns in the form of above-average interest rates, in addition to leveraging equity warrants, which can result in immediate ownership of a stake in the company, or allow the lender to buy the stock at a favorable, predetermined price within a specific timeframe.
A mezzanine loan, often interchangeably referred to as mezzanine debt, is typically used by corporations looking for additional funding beyond assets already provided by banks or senior lenders but is also commonly utilized by real estate borrowers. Alternatively, mezzanine financing may be used by a business that may not have access to senior debt or is otherwise not prepared to take on the obligations associated with a traditional loan.
How do mezzanine loans work?
Mezzanine loans are important vehicles for businesses seeking alternative sources of capital and additional flexibility when it comes to managing their budget. Beyond securing assets to promote growth in the company, or to aid recapitulation efforts and restructure debt, mezzanine financing can allow a business to take advantage of an acquisition or leveraged buyout opportunity.
For investors and lenders, mezzanine loans are attractive for their combined utilization of unusually high-interest rates—sometimes as high as 30%—and strategically negotiated equity warrants. While mezzanine financing has an inherently elevated risk profile due to its inclusion of subordinated debt, lenders may find that the potential for reward outweighs the risk, particularly when a borrower has a proven track record for growth and proper documentation revealing positive cash flows.
Mezzanine financing usually takes the form of a long-term loan of capital, with an average term of five years. Mezzanine debt is often referred to as “patient debt,” as it allows businesses to make monthly, quarterly, or annual interest payments, and has no amortization, meaning the principle can be paid off in a single sum at the end of the term.
Structurally, mezzanine loans are fairly flexible and can be issued in a variety of ways, almost all of which utilize some combination of subordinated debt and equity financing. However, in most cases, a mezzanine loan consists of a simple issuance of subordinated debt in addition to equity warrants. Because the loan is unsecured, the equity warrants exist as a kind of insurance policy for lenders in the event that the borrower defaults, allowing them to convert the remaining debt into equity shares in the business after senior lenders and investors have been reimbursed.
If equity warrants are excluded from a mezzanine loan contract, it is usually because the borrower is backed or sponsored by private equity. When this is the case, the lender is most likely to request an equity co-investment as part of the agreement, as it allows the lender to generate returns outside scheduled interest payments on the loan.
Pros and cons of mezzanine loans
All forms of debt have different stipulations and come with a variety of potential benefits and pitfalls. Let’s take a look at the pros and cons of mezzanine loans for businesses, before briefly presenting some alternative financing options.
Many businesses need growth capital to expand their operations, but may not currently be large or profitable enough to secure a traditional bank loan or attract investments from venture capital or private equity firms. In this case, mezzanine financing can serve as an alternative option for securing debt.
Con: High-interest rates
As previously mentioned, mezzanine loans invariably come with high-interest rates, which may not be reasonable for some borrowers. Businesses that aren’t currently turning a profit or don’t have reliably positive cash flows may find it hard to make scheduled interest payments or repay the principal once the loan has reached maturity.
Mezzanine loans are often highly flexible, and many businesses find them less oppressive and easier to manage than senior debt. For example, if a borrower can’t make a monthly interest payment, the structure of most mezzanine loans allows the interest to be carried over to the principal balance.
Con: Complex and time-consuming
Due to both the structural complexity of the loan and the need to draft separate inter-creditor agreements to satisfy both senior and subordinated lenders, securing a mezzanine loan can be a time-consuming process. Taking as long as six months to finalize, mezzanine financing may not be preferable for businesses looking for working capital in the short term.
Pro: Lower cost of capital
For the most part, mezzanine financing is considered to be less expensive than raising equity. Interest paid on mezzanine debt constitutes a tax-deductible expense on a company’s balance sheet and serves to bring down the weighted average cost of capital (WACC).
Con: Equity risks
The equity participation aspect of most mezzanine loans introduces an additional layer of risk to borrowers. A lender capitalizing on a right to buy at a predetermined price, or executing a “put" option, could inflict financial damage. Additionally, while it isn’t too common, mezzanine lenders might request a board seat as part of the agreement, shifting the balance of control within an organization.
Pro: Less restrictive covenants
Almost all forms of debt come with contractual provisions such as covenants, which require the borrower to take or avoid certain actions over the term of the loan. Mezzanine loans may come with restrictive covenants such as enforcing the proper maintenance of financial records, or stipulations regarding when or if a borrower may take on additional debt, however, these tend to be less restrictive than the covenants enforced by senior lenders.
Alternatives to mezzanine financing
Traditional business loan: While some businesses choose mezzanine loans because they have maxed out the funds available from senior lenders, others simply don’t want to enter a more traditional, secured loan agreement with a bank or private company.
But for businesses who don't mind providing a personal guarantee, shopping around for a business loan from a traditional financial institution may be a better way to borrow the funds they need at a more reasonable interest rate.
Preferred stock: When a business needs an alternative financing option but doesn’t want to add more debt to the balance sheet, it may decide to issue preferred stock to an investor. Rather than paying interest rates, the business pays regular dividends to preferred stockholders.
While this is less risky than issuing common stock because preferred shareholders have less decision-making power, dividends are not tax-deductible, and introducing preferred shares adds complexity to how dividends are managed and paid out.
Business line of credit (LOC). Similar to a business credit card, but different than a business loan, a line of credit can be a great alternative option for companies who need immediate access to working capital.
While securing a line of credit with a high enough limit to meet objectives has often been difficult for small businesses, services like Ramp’s commerce sales-based underwriting can help secure limits up to 30X higher than traditional offerings. The process is less complex and time-consuming than securing a mezzanine loan, and both your limit and interest rate will be determined based on the performance of your business rather than your current account balance.
Where to get a mezzanine loan & what to do next
If you’re looking for a mezzanine loan, the good news is that you won't have to look too hard to find a lender. Mezzanine financing is its own industry, and while you won't find a provider at a traditional bank or credit union, there are plenty of options available.
For the most part, you’ll be dealing with a specialized mezzanine fund, and these exist in many forms, such as a Small Business Investment Company (SBIC) or Business Development Company (BDC). Additionally, hedge funds and private equity firms may offer separate mezzanine lending services.
Once you receive a mezzanine loan, the best next step is to shift your focus to financial planning and optimize processes around expense management. This will not only be critical to your ability to meet repayment obligations, it will ensure that the funds you've borrowed are being used as effectively as possible to promote the growth of your business.
Fortunately, Ramp has all the tools you need to make the most of your recently secured financing. Features like real-time expense tracking improve transparency and record-keeping processes, while our spending controls can be leveraged to limit access to funds based on user, or restrict purchases from certain vendors. Moreover, Ramp’s APIs are easily integrated with your accounting software of choice, making the process less of a complicated and stressful transition, and more of a strategic activation of enhanced expense management capabilities.
Interested in how Ramp’s tools can help you make the most of your loan, or how our underwriting process can help secure funds for your business? Get started here.