Mezzanine Financing: What it is, pros and cons

If you’re raising growth capital to expand your business, you may want to consider using mezzanine financing as part of your funding solution.

Mezzanine financing is a form of debt that can be a great tool to fund specific initiatives like plant expansions or launching new product lines, as well as other major strategic initiatives like buying out a business partner, making an acquisition, financing a shareholder dividend payment or completing a financial restructuring to reduce debt payments.

It is commonly used in combination with bank-provided term loans, revolving lines of credit and equity financing, or it can be used as a substitute for bank debt and equity financing.

This type of capital is considered “junior” capital in terms of its payment priority to senior secured debt, but it is senior to the equity or common stock of the company. In a capital structure, it sits below the senior bank debt, but above the equity.

Pros:

1. Mezzanine Financing Lenders are Cash Flow, Not Collateral Focused: These lenders usually lend based on a company’s cash flow, not collateral (assets), so they will often lend money when banks won’t if a company lacks tangible collateral, so long as the business has enough cash flow available to service the interest and principal payments.
2. It’s a Cheaper Financing Option than Raising Equity: Pricing is less expensive than raising equity from equity investors like family offices, venture capital firms or private equity firms – meaning owners give up less if any, additional equity to fund their growth.
3. Flexible, Non-Amortizing Capital: There are no immediate principal payments – it is usually interest-only capital with a balloon payment due upon maturity, which allows the borrower to take the cash that would have gone to make principal payments and reinvest it back into the business.
4. Long-Term Capital: It typically has a maturity of five years or more, so it’s a long-term financing option that won’t need to be paid back in the short term – it’s not usually used as a bridge loan.
5. Current Owners Maintain Control: It does not require a change in ownership or control – existing owners and shareholders remain in control, a key difference between raising mezzanine financing and raising equity from a private equity firm.

Con’s

1. More Expensive than Bank Debt: Since junior capital is often unsecured and subordinate to senior loans provided by banks, and is inherently a riskier loan, it is more expensive than bank debt
2. Warrants May be Included: For taking a greater risk than most secured lenders, mezzanine lenders will often seek to participate in the success of those they lend money to and may include warrants that allow them to increase their return if a borrower performs very well

When to Use It

Common situations include:

• Funding rapid organic growth or new growth initiatives
• Financing new acquisitions
• Buying out a business partner or shareholder
• Generational transfers: a source of capital allowing a family member to provide liquidity to the current business owner
• Shareholder liquidity: financing a dividend payment to the shareholders
• Funding new leveraged buyouts and management buyouts.

Great Capital Option for Asset-Light or Service Businesses

Since mezzanine lenders tendency is to lend against the cash flow of a business, not the collateral, mezzanine financing is a great solution for a funding service business, like logistics companies, staffing firms and software companies, although it can also be a great solution for manufacturers or distributors, which tend to have a lot of assets.

What mezzanine finance lenders look for

While no single business funding option is suited for every situation, here are a few attributes cash flow lenders look for when evaluating new businesses:

• Limited customer concentration
• A consistent or growing cash flow profile
• High free cash flow margins: strong gross margins, low capital expenditure requirements
• Strong management team
• Low business cyclicality that might result in volatile cash flows from year to year
• Plenty of cash flow to support interest and principal payments
• An enterprise value of the company well in excess of the debt level

Non-Bank Growth Capital Option

As bank lenders face increasing regulation on tangible collateral coverage requirements and leveraged lending limits, the use of alternative financing will likely increase, particularly in the middle market, filling the capital void for business owners seeking funds to grow.