What is mezzanine financing?
Mezzanine financing is a hybrid form of debt and equity financing, similar to a SAFE or convertible note, except that it gives the lender the right to convert its debt position into an equity interest in the event of default (unlike a SAFE, where the trigger for equity conversion is not a default). The equity component is in the form of warrants, which enable the lender to achieve a greater level of flexibility when dealing with bondholders. The debt component is in the form of a loan, which enables the lender to collect monthly payments. In some cases it comes with a bullet maturity, meaning there is no amortization during the life of the loan and the borrower pays interest-only payments each month.
How does mezzanine financing work?
Since mezzanine financing is a hybrid form of equity and debt, it functions similarly to both. It provides the lender with some of the same rights typically reserved for equity investors, while simultaneously enabling them to get repaid through monthly interest-only (usually between 12% and 20% per year). It is senior to pure equity and subordinate to pure debt in the waterfall payment scheme, typically comes with a small payback period (1-6 months) and comes with few collateral requirements. As with most forms of financing, the startup and the financier sign an agreement outlining all of the terms of the financing prior to distributing/receiving funding.
Why is mezzanine financing used?
Since mezzanine financing typically comes with shorter payback periods, it is most frequently used by startups to fund short term growth projects and acquisitions (e.g. its common to take it while raising an equity round as a bridge to round close). The hybrid form of financing enables startups to minimize the debt on their balance sheet, while simultaneously preserving their ownership stake. Since it typically doesn’t come with required monthly repayments (other than the interest-only monthly payments required by some financiers), the startup has more capital available to it to invest in its growth.
What does mezzanine financing cost?
Since mezzanine financing is a hybrid form of financing, it's more expensive than senior debt, but it's less expensive than equity. It’s most commonly classified as subordinated debt, since it is junior to senior facilities such as venture debt.
Can you provide an example of mezzanine financing in action?
Jermaine Bank, provides Lisa LTD with $1M in mezzanine financing. Jermain Bank and Lisa LTD agree on a maturity date one year from now with a bullet structure and a 10% interest rate. Lisa LTD makes their monthly interest-only payments, Lisa LTD grows significantly over the year, and upon maturity of the loan, they repay the principal. In this example, the mezzanine financing worked exactly as intended.
When do startups typically leverage mezzanine financing?
Some of the most common uses for mezzanine financing include: acquisitions, growth plans, recapitalizations, leveraged buyouts, management buyouts, shareholder buyouts, refinancings, and balance sheet restructuring or optimization.
What are the advantages of raising capital via mezzanine financing?
Mezzanine financing comes with some of the benefits of both equity and debt financing – some of these advantages include:
- Being more manageable than other forms of debt – since they typically don’t require a significant amount of collateral
- Deductible interest payments - startups that take mezzanine financing can write off any interest that they pay.
- Varied repayment options - startups that take mezzanine financing can pay interest charges, add them to the loan balance (due upon maturity), or provide equity-like instruments to the lender. Also, lower monthly payments during the life of the loan means no near term negative impact to business expenses.
Mezzanine financing also provides more flexibility compared to traditional bank loans (e.g. looser covenants, reduced amortization, fewer restrictions), it costs less and enables founders to preserve more of their ownership stake (equity-only financing). By leveraging mezzanine financing to grow, startups can restructure the financing into more senior debt at a lower interest rate, saving them both interest and equity.
What are the disadvantages of raising capital via mezzanine financing?
Raising capital via mezzanine financing comes with several disadvantages including:
- Higher costs - Mezzanine financing costs more than senior debt (since its subordinated debt)
- Bullet structure - With Mezzanine financing, a huge payment comes due upon maturity, which is very hard to cover if company does not secure permanent/alternate financing.
- Equity dilution - Mezzanine financing dilution is punitive. It's in the the form of repayment upon loan default, so the lender takes a high level of EQ as a form of repayment
- More restriction - Mezzanine financing typically comes with more restrictions than forms of debt-only financing –e.g. covenants and creditor rights
The other major drawbacks are the prepayment penalties that come with most mezzanine financing offers and the timeline from initial contact to close (often three to six months).
Where does mezzanine financing sit in the capital stack?
Mezzanine financing is subordinate to senior debt, but superior to both preferred and common stock. A few of the common forms of mezzanine financing include senior subordinated debt, convertible subordinated debt and redeemable preferable stock.
What are the typical terms associated with mezzanine financing?
- Loan Amount - this describes the amount of capital you are able to access.
Interest Rate - this is the amount of interest that you will be charged on the principal.
- Maturity Date - this is the date when the principal (and interest in some cases) is due.
Collateral - this refers to the assets that the lender accepts as security for a loan.
- Warrant Coverage Provision - this outlines the amount of shares you allow the financier to acquire at a predetermined price.
- Bullet Provision - this outlines whether or not your monthly payments include principal repayments or if your monthly payments are interest-only.
- Other Contractual Provisions - this outlines all of the other terms of the financing agreement.
Can you negotiate the terms of mezzanine financing?
Yes As with most forms of financing, the terms are negotiable.
Our thoughts on mezzanine financing
Mezzanine financing can be a good option for startups that want to complete an acquisition in the next 6-9 months, need financing for their growth plans, or as a bridge while they raise permanent capital. Startups who leverage this form of financing, benefit from deductible interest payments, and the varied repayment options, but suffer from the high interest rates and risk of significant dilution in event of default.
While mezzanine financing is useful for startups in certain situations, a more founder-friendly alternative for companies with growing revenues is revenue based financing. This form of financing enables them to convert their future revenues into upfront capital. Unlike mezzanine financing, there is no convertible equity component, the total cost of capital is known upfront, and there is no recourse in the event of default. Learn more about this form of financing here.