Mezzanine Financing (Mezzanine Debt)

What is Mezzanine Financing?

Mezzanine financing is a hybrid of debt and equity that ranks below senior debt but above common stock in a capital structure.  Since mezzanine financing is usually structured as subordinated debt, the terms mezzanine financing and mezzanine debt are often used interchangeably.  Both terms are often shortened to mezz financing and mezz debt.

 

Due to the risk profile of mezzanine financing, lenders require a higher return than senior lenders and a lower return than equity investors.  Lenders achieve this through a combination of interest payments and equity participation.

 

Mezzanine debt is used when a company has maximized its bank and asset-based loans but needs additional funding to expand operations, make an acquisition, or buy out a partner.  Although it’s unusual, some borrowers only have mezzanine debt due to an inability or unwillingness to borrow senior debt for several possible reasons (e.g. lack of collateral or reluctance to provide personal guarantee).

 

Both corporate and real estate borrowers utilize mezzanine debt, but the focus of this overview is the corporate market.

 

If you have a company with EBITDA of $1 million or more, then you might be able to obtain mezzanine financing.  At Find Venture Debt, we have a fast, easy process to determine whether you qualify.  Contact us to get started.

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How Does Mezzanine Financing Work?

Mezzanine financing is a flexible form of long-term capital which includes the following structures:

  • Subordinated debt plus an "equity kicker" in the form of warrants to purchase common stock;
  • Subordinated debt plus an equity co-investment;
  • Subordinated debt without equity;
  • Convertible debt; and
  • Preferred equity.

The most common structure is a subordinated, unsecured term loan plus warrants. Since the loan is subordinated and unsecured, borrowers must have positive cash flow. Interest payments are due monthly or quarterly but may accrue during an initial period(e.g. twelve months), increasing the principal balance. Normally, the term is five years with no amortization; principal is repaid at final maturity.

In recent years, mezzanine debt has faced increased competition from other types of debt financing, especially second lien term loans and unitranche financing. As a result, mezzanine lenders have been forced to lower their interest rates and reduce or eliminate their demand for warrants.

In prior years, mezzanine funds had targeted blended returns (interest plus equity participation) in the high teens and pricing was relatively uniform across lenders. Currently, expected returns range from approximately 10% to the high teens, depending on the borrower’s characteristics.

Two primary considerations are whether the borrower is sponsored (backed by a private equity firm) or non-sponsored, and the EBITDA of the borrower. In most sponsored deals, the mezzanine lender does not receive warrants. For pricing purposes, the EBITDA brackets are roughly $1-5 million, $5-20 million, and over $20 million. As expected, the higher the EBITDA, the lower the pricing.

To boost their portfolio returns, in lieu of warrants, some lenders will request the right to make an equity co-investment.

Use Cases for Mezzanine Debt

There are many uses for mezzanine debt. Since mezzanine debt is the most expensive form of debt, it is only used when the alternative would be raising additional equity. Mezzanine is commonly used to facilitate a transaction such as an acquisition or shareholder buyout. It can also be used to fund organic growth opportunities that are relatively low risk (otherwise equity should be used).

Since mezzanine debt typically has a five-year term and is interest-only until principal is due at maturity, it is considered patient capital. The borrower has five years to build its business prior to repaying the debt or replacing it with a lower cost alternative.

Specific use cases for mezzanine debt include:

  • Growth capital: Using mezzanine financing as growth capital can help a company accelerate its organic growth. Funds can be used for investment in product development, sales and marketing, equipment purchases, or facility expansion.
  • Acquisitions: Mezzanine debt is often used for acquisition financing. Acquisitions can provide access to complementary technologies, products and customers, and facilitate entry into new distribution channels and geographic markets.
  • Leveraged buyouts: Private equity funds often utilize mezzanine debt to reduce the equity they invest in a transaction.  If the transaction is successful, the additional financial leverage will increase the internal rate of return on their equity.
  • Management buyouts: In a management buyout, a company’s current management acquires control of the business from a parent company or investors. Since management teams often have limited equity, mezzanine capital can be a critical element of the financing structure.
  • Shareholder buyouts: Mezzanine debt can be utilized if a company needs to repurchase shares from a retiring founder, family member, passive investor, or disgruntled shareholder. In effect, equity is replaced by debt in the capital structure.
  • Recapitalizations: A recapitalization is a restructuring that materially changes the mix of debt and equity in a company’s capital structure.  A common reason for a recapitalization is to provide partial liquidity to shareholders through a dividend or share repurchase.
  • Refinancings: In a refinancing, the proceeds from mezzanine debt can be used to repay debt that is maturing, or prepay debt to take advantage of lower interest rates and/or better terms.

What do Lenders Look for in Potential Borrowers?

For technology and growth companies, the biggest hurdle to obtaining mezzanine financing is that borrowers need to be cash flow positive with EBITDA of at least $1 million, and preferably more than $2 million.

Mezzanine Financing Qualifications

  • Industry: Can be technology or non-technology sector but mezzanine lenders avoid sectors where business models are     subject to rapid change.
  • Business model: Business model should be proven and stable. As with other types of debt, companies with recurring revenue business models are particularly attractive. Mezzanine lenders avoid early-stage, turnaround, or highly cyclical businesses.
  • Size:  Varies by lender. Minimum is usually based on EBITDA rather than revenue. However, annual revenue of at least $5 million is a reasonable guideline for minimum. Practically speaking, there is no maximum.
  • Growth: Positive historical and projected growth.
  • Profitability: Business must be profitable, usually with EBITDA of $1 million or more (see exceptions noted below).
  • Existing debt: Senior obligations are permitted but mezzanine lenders may require limits.
  • Ownership: Depends on lender, but can be sponsored  or non-sponsored.  Interest rates and terms are generally better for sponsored companies.

There are two exceptions to the EBITDA requirement:

  • Recurring revenue: Some mezzanine lenders will provide funding to companies with recurring revenue business models, solid growth, strong gross margins, and a clear path to profitability in 1-2 years.
  • Mezzanine funds that are equity-oriented: A key characteristic of mezzanine financing is its flexibility.  While most mezzanine funds are lenders first and equity investors second, there are some that are more equity-oriented.  Of course, since their perceived risk is higher, they require a higher return on investment but not as high as pure equity investors.

 

Mezzanine financing is one of the most flexible sources of growth capital.  If your company qualifies, Find Venture Debt provides a fast, easy process for connecting with lenders. Contact us today to learn more.

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What are the Key Provisions of a Mezzanine Financing Term Sheet?

Mezzanine loan terms depend on the risk profile of your company and the preferences of each lender.  As previously discussed, terms also vary depending on sponsorship and EBITDA.  Mezzanine debt terms include the following:

  • Structure: The most common structure for mezzanine financing is unsecured subordinated debt. Historically, the mezzanine lender received an "equity kicker" in the form of warrants to purchase common stock. In recent years, lenders have only     received warrants from non-sponsored and smaller borrowers.
  • Amount:  Depends on the revenue, profit margins, existing financial leverage, and other factors. The minimum loan is typically $500,000; the maximum can exceed $100 million.
  • Term: Usually 5 years.
  • Amortization: Usually structured as interest-only with 100% of principal due at final maturity (also called a "bullet loan").
  • Interest: 10% to 14% annually. Borrowers with EBITDA greater than $20 million can obtain rate below $10%.
  • Equity participation: Mezzanine lenders usually require warrants or other equity kicker to achieve their target return on investment. The ownership percentage will vary depending on the lender's required return, the risk and projected growth of the business, and other factors.
  • Collateral requirements: Usually none. Mezzanine debt is generally an unsecured obligation, which is the primary reason it’s only available to profitable companies. Unlike second lien, mezzanine financing is a true “silent second” behind the senior.
  • Restrictive covenants: Generally, includes minimal financial maintenance covenants such as coverage ratios. However, the lender will likely require affirmative covenants and negative covenants. Affirmative covenants require the borrower to take certain actions such as paying required taxes, maintaining financial records, maintaining adequate insurance, etc. Negative covenants limit actions that the borrower can take without the lender's permission such as borrowing additional money, paying dividends to shareholders, selling the company's assets, or other actions that may affect the company's ability to repay.
  • Governance: Some, but not all, mezzanine funds require board seats or other direct involvement in the governance of the     company. It also depends on the specific situation, especially the lender's ownership percentage.
  • Personal guarantee: Usually not required.
  • Access and audit rights:  Requires access to financial statements and bank account data to monitor company's financial performance and verify compliance with loan agreement.

If the business has multiple lenders, an intercreditor agreement is usually required. This is an agreement between the senior and subordinated creditors, which specifies how their relative rights and obligations are enforced in a distress or bankruptcy situation.

 

Unfortunately, lenders often write term sheets in an overly technical manner. This can make it difficult to understand the key business terms and even more difficult to compare term sheets from multiple lenders. At Find Venture Debt, we have extensive experience reviewing term sheets. Let us know if we can help you.

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The Pros and Cons of Mezzanine Financing

Mezzanine financing is one of the most flexible sources of growth capital, and can be a great alternative to raising equity.  Of course, no type of financing comes without drawbacks.  Unlike equity, debt requires periodic interest payments and the principal must be repaid upon maturity.

The pros (advantages) of mezzanine financing include:

  • When properly structured, debt financing is substantially less expensive than equity financing. By utilizing mezzanine debt in its balance sheet, a company can lower its weighted average cost of capital (WACC).
  • Less dilutive so management or investors can keep a much larger percentage of ownership.
  • For companies that don't qualify for sufficient bank debt or have strong cash flow but need flexible terms, mezzanine funds can provide a “one-stop” debt solution.
  • Mezzanine financing can be a great alternative when a company needs growth capital but is not growing fast enough or is not large enough to attract institutional investors (venture capital or private equity) or is not satisfied with the terms offered by such investors.
  • Can be used as bridge financing prior to an equity financing or public offering.
  • Depending on the size of their equity interest, mezzanine lenders may not require board seats or other direct involvement in the governance or operations of the company.
  • Generally, mezzanine funds do not want to be long-term shareholders. Equity is a tool for boosting the return on their lending portfolio.
  • Personal guarantee is generally not required.
  • Collateral is generally not required for mezzanine financing.
  • Covenants are less restrictive than senior debt.
  • Borrower does not have to be sponsored by a venture capital or private equity firm.
  • Due diligence process is simpler and faster than an equity fundraising.
  • Mezzanine funds have been facing competitive pressure from other forms of finance, which may force them to improve their pricing and terms.

The cons (disadvantages) of mezzanine financing include:

  • The business must be profitable and have sufficient cash flow to make scheduled principal and interest payments.
  • Mezzanine financing usually has a much higher interest rate than senior debt due to its riskier position in the capital structure.
  • Mezzanine funds require equity participation. In some cases, the investor has a “put” right, so the company has to repurchase the equity investment based upon a formula after a set period of time.
  • It can be difficult to estimate the cost of capital, especially if the company has substantial upside potential.
  • If a company is required to borrow the entire principal amount up front, the cost may be higher than lines of credit which are drawn as needed.
  • Since the business will have a senior lender and a subordinated lender, an intercreditor agreement will be required, which adds complexity, time and expense to the process.

Where to Get Mezzanine Financing

There are hundreds of mezzanine finance providers in the U.S.  Banks are not actively involved in mezzanine lending.  Most loans are provided by specialized mezzanine funds and other non-bank lenders. These include Business Development Companies (BDC), Small Business Investment Companies (SBIC), mezzanine funds associated with private equity groups, and hedge funds.

 

Each mezzanine lender has a unique set of investment criteria.  These primarily focus on borrower characteristics such as sponsored vs. non-sponsored, revenue, EBITDA, growth rate, industry, and geographic location.

 

In addition, mezzanine lenders have preferences regarding risk tolerance, return expectations, investment size and structure, and loan rates and terms.

How Do I Start the Process to Obtain Mezzanine Financing?

To obtain debt financing, you need the right partner. Find Venture Debt can help you determine whether your company qualifies.  If it does, we’ll identify the type of debt that best fits your company and provide access to our extensive network of bank and non-bank lenders that have the capital you need to grow your business.

 

We help you through the entire process. All you have to do to get started is fill out our simple online form.

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Mezzanine Financing Frequently Asked Questions (FAQ)

 

Below we’ve answered the most commonly asked questions pertaining to mezzanine financing.  If you don’t see your question here, please reach out to us and we’ll get back to you with an answer!

What are the alternatives to mezzanine debt?

There are two primary alternatives to mezzanine debt:

  • second lien loan is similar to senior debt but has a second rather than first lien on collateral. Combining a line of credit or senior term loan with debt that is slightly junior provides additional capital to a business at an attractive blended interest rate.
  • A unitranche loan combines senior and subordinated into a single facility with a blended rate.

Generally, these alternatives do not require equity participation. However, the trade-off is that the total funding available to a business is likely to be less than a combination of senior and mezzanine financing. Selecting the optimal alternative depends on the amount of capital needed and conditions in the lending market. For a relatively small company (EBITDA of $5 million or less), second lien is more likely to be available than unitranche.

Is mezzanine debt or equity?

In its most common form, mezzanine financing is a hybrid of debt and equity.

How is mezzanine financing similar to debt?

  • Mezzanine financing minimizes dilution, so management or investors can keep a much larger percentage of ownership.
  • Principal and interest payments must be made according to an agreed upon schedule. Failure to make these payments can result in bankruptcy.
  • In a sale or liquidation of the company, mezzanine lenders must be repaid before common and preferred stockholders.
  • The cost of capital is less than common or preferred stock.

How is mezzanine financing similar to equity?

  • Mezzanine funds participate in any increase in value of the company.
  • The cost of capital is higher than senior debt due to the higher risk.
  • Mezzanine funds may require board seats or other direct involvement in the governance of the company.

Is mezzanine debt secured?

Mezzanine debt is normally an unsecured obligation of the borrower.  In the event of default, the lender cannot claim specific assets of the borrower to satisfy the debt.

Can subordinated debt be secured?

Technically, subordinated debt can be secured. However, it is likely that any senior lender would object to ranking below a secured, subordinated lender. Therefore, if subordinated debt is secured, it will likely have a second lien behind the senior lender rather than a first lien.  This is commonly referred to as a second lien term loan.

How does mezzanine debt compare to bank debt?

Banks are highly regulated, which limits the amount they can lend to a company and requires stringent covenants. The use of mezzanine financing enables companies to increase the total amount they can borrow and provides flexibility in structure and terms. The trade-off is that mezzanine debt is more expensive than bank debt.

How does mezzanine debt compare to an MRR line of credit or revenue-based financing (RBF)?

In some ways, they are more alike than different. All can be used to complement or replace traditional bank financing, and all are less expensive than equity. However, they differ in structure and the situations in which they are best used. From an equity dilution perspective, MRR lines and mezzanine financing tend to be minimally-dilutive, while RBF is usually non-dilutive.

Mezzanine financing vs. convertible debt?

Mezzanine financing usually has equity participation in the form of warrants. A convertible structure allows the lender to convert all or a portion of the principal into equity of the borrower. Convertible debt tends to have lower interest payments but higher equity dilution than a structure with warrants. 

What is the difference between mezzanine debt and subordinated debt?

The most common structure for mezzanine debt is unsecured, subordinated debt so they are fundamentally the same.  The key difference is that mezzanine debt usually refers to debt that is coupled with equity participation, which is not usually true for subordinated debt.

What is a mezzanine debt fund?

A mezzanine debt fund is a pool of capital that is dedicated to providing mezzanine loans to borrowers.  In recent years, mezzanine debt funds have faced increased competition from lenders that provide second lien term loans and unitranche financing.  As a result, many mezzanine funds have expanded their offerings to include second lien, unitranche, mezzanine, and equity co-investments.

How do you calculate the all-in cost of mezzanine financing?

The all-in cost of capital is typically in the range of 14-20% per year including the following:

  • Interest;
  • Equity participation; and
  • Fees (one-time or periodic).

Due to the equity feature, the cost of mezzanine financing must be estimated using an Excel model. There are two primary methods:

  • Method #1 treats the equity as an upfront fee paid by the borrower.
        Step 1: Calculate the value of the equity participation as of the issuance date using the Black-Scholes option pricing model. If the equity kicker is in the form of warrants with an exercise price of $0.01(also known as "penny warrants"), they are basically worth the value of the underlying security.
        Step 2: Deduct the value of the equity and any upfront fees from the principal amount (similar to an original issue discount or "OID").
        Step 3: Calculate the effective interest rate.
  • Method #2 is a more traditional cash flow analysis.
        Step 1: Deduct the value of any upfront fees from the principal amount at issuance (the warrant value is not included in the calculation).
        Step 2: Estimate the timing and amount of proceeds from an exit event for the equity.
        Step 3: Calculate an internal rate of return for the investment including all cash flows. This approach is more complicated than the first since it requires estimating the future value of the business.

In theory, both approaches should provide the same answer but that is often difficult to achieve in practice. However, the reconciliation process can be beneficial for identifying the key factors that impact cost and understanding the sensitivity to different assumptions.

The cost of mezzanine financing should be evaluated in the context of other alternatives. Ideally, each alternative should be modeled using a consistent methodology with multiple scenarios (e.g. base, upside, downside) for comparative purposes. Of course, non-financial terms and conditions must also be considered in selecting the optimal alternative.

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