Overview of mezzanine financing: what it is, pros and cons and common situations
If you are raising growth capital to expand your business, you may consider using mezzanine financing as part of your financing solution.
Mezzanine financing is a form of debt that can be a great tool for financing specific initiatives such as expanding plants or launching new product lines, as well as other large strategic initiatives such as buying out a business partner, making an acquisition, financing dividend payments to shareholders or completing a financial restructuring to reduce debt payments.
It is typically used in combination with bank term loans, revolving lines of credit and equity financing or can be used as a substitute for bank debt and equity financing.
This type of equity is considered “junior” equity in terms of its priority of payment to senior secured debt, but it is senior to the company’s equity or common stock. In a capital structure, it is below principal bank debt but above equity.
- Mezzanine finance lenders are focused on cash flow rather than collateral: These lenders typically lend based on a company’s cash flow rather than collateral (assets), so they will often lend money when banks won’t if the company lacks collateral, as long as the business has enough cash flow available to service interest and principal payments.
- This is a cheaper financing option than raising equity capital: Pricing is cheaper than raising capital from equity investors such as family offices, venture capital firms or private equity firms – meaning owners give up less, if any, additional capital to fund their growth.
- Flexible, non-depreciating capital: There are no immediate principal payments – this is usually interest-only capital with a balloon payment due at maturity, allowing the borrower to take the money that would have gone towards making principal payments and reinvest it back into the business.
- Long-term capital: It usually 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 bridging loan.
- 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 capital from a private equity firm.
- More expensive than bank debt: Because junior equity is often unsecured and subordinated to senior loans provided by banks, and is inherently a riskier loan, it is more expensive than bank debt
- Warrants may be included: To take on more risk than most secured lenders, mezzanine lenders will often seek to share in the success of those they lend money to, and may include guarantees that allow them to increase their returns if the borrower performs very well good
When to use it
Common situations include:
- Funding rapid organic growth or new growth initiatives
- Financing of new acquisitions
- Buyout of a business partner or shareholder
- Intergenerational transfers: A source of capital allowing a family member to provide liquidity to the current business owner
- Shareholder liquidity: financing of dividend payments to shareholders
- Financing new leveraged buyouts and management buyouts.
Great capital option for asset light or service businesses
Since the tendency of mezzanine lenders is to lend against the cash flow of the business rather than the collateral, mezzanine financing is a great financing solution for business services such as logistics companies, staffing firms and software companies, although it can also be a great solution for manufacturers or distributors who tend to have a lot of assets.
What are these lenders looking for?
While no single business financing option is right for every situation, here are a few cash flow attributes that lenders look for when evaluating a new business:
- Limited customer concentration
- A steady or growing cash flow profile
- High free cash flow margins: strong gross margins, low capital expenditure requirements
- Strong management team
- Low business cyclicality, which can result in variable cash flows from year to year
- Plenty of cash flow to support interest and principal payments
- Corporate value of the company that significantly exceeds the level of debt
Non-bank growth capital option
As bank lenders face increased regulation regarding collateral coverage requirements and leveraged lending limits, the use of alternative financing is likely to increase, particularly in the middle market, filling the capital gap for business owners who looking for funds to grow.
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