According to the Alliance for Financial Inclusion, 40 percent of businesses struggle to access reliable financing. The outcome of this struggle can make or break the average enterprise, and the Bipartisan Policy Center describes credit as “essential” – especially for small businesses. As companies consider their full range of financing options, they may encounter the concept of mezzanine financing. Although this is just one example of alternative lending, it can offer numerous benefits. After discussing this option in more detail alongside a business law
attorney in Arizona, companies can determine whether mezzanine financing serves their unique needs. Contact Harrison Law, PLLC at (480) 320-2310 to receive targeted guidance on this complex subject.
Where Did Mezzanine Financing Get Its Name?
In the world of architecture, a “mezzanine” is an intermediary floor between the first and second levels. “Mezzo” is the Italian word for “half.” The term “mezzanine financing” or “mezzanine capital” references the intermediary, “hybrid” nature of this funding strategy.
Mezzanine financing combines elements of both senior debt and equity financing. Most company leaders understand that senior debt represents the loans that the company must pay back first if it declares bankruptcy. In other words, the company must prioritize senior creditors over subordinated or “junior” debt. On the other hand, equity financing involves selling company shares in order to raise capital.
How Does Mezzanine Financing Combine Senior Debt and Equity Debt?
The hybridization of senior debt and equity debt is relatively straightforward. Under certain circumstances, a system of “warrants” allows investors to convert their senior debt into equity debt. Note that these circumstances vary depending on the specific debt agreement. Often, bankruptcy triggers equity options – but this is not always the case. Sometimes, creditors have the option to convert their debt to shares at a specific date, an arrangement which can help to address potentially late repayment.
In some cases, companies may intentionally “default” on mezzanine financing loans in order to avoid repayment, gain access to more capital, and instead accept the conversion of senior debt to equity debt. If the company manages to repay the debt, investors still benefit from higher interest fees compared to normal senior debt. Investors receive these payments periodically, and the higher level of cash interest stems from the higher risk investors entail compared to senior debt. Assuming that they never convert debt to equity, investors can also receive other possible returns, such as arrangement fees, payment-in-kind interest, and participation buyouts.
Examples of Mezzanine Financing
Mezzanine financing is a general term that may refer to several specific financing options. Companies may structure this debt as preferred stock – shares that have special rights and privileges not available to common investors. Mezzanine financing may also take the form of senior subordinated debt or convertible subordinated debt. To learn more about these options, consider consulting with Harrison Law, PLLC.
Is Mezzanine Financing Risky?
In terms of risk level, mezzanine finance lies somewhere between senior debt and equity financing. While it may not offer risk levels as low as senior debt, it still provides greater lending confidence than equity financing. In the event of a normal bankruptcy, shareholders typically suffer the greatest losses because senior debt takes top priority. With its in-between status, mezzanine financing offers a risk compromise.
What Happens if You Default on a Mezzanine Loan?
If a company defaults on a mezzanine loan, this may trigger the warrant option of the debt agreement. As a result, the creditor may convert their loan to equity and own a part of the business. If the mezzanine loan is secured by a majority share of the business, the lender may become the new majority owner of the company. As such, they will receive new voting powers that could potentially allow them to control the trajectory of the company. If the company is no longer viable, however, taking ownership may not be an attractive prospect. The company must still repay senior creditors before mezzanine creditors in the event of bankruptcy.
Mezzanine Financing: Advantages and Disadvantages
Mezzanine financing offers a range of potential advantages and disadvantages. Note that these pros and cons may apply to both investors and company owners. Consider these factors before taking the next steps toward mezzanine loans.
Mezzanine Financing Advantages
Mezzanine financing theoretically allows businesses to obtain more credit than they would normally have access to. Due to various regulations, banks can only provide a single business with a certain amount of credit – but equity in the form of mezzanine loans may not count toward total credit calculations. Mezzanine financing has proven popular among companies seeking to fund future projects – including mergers and acquisitions. However, businesses seeking additional financing should bear in mind that these regulations are in place to help prevent defaults, and taking on more debt can be disadvantageous as well as advantageous.
Investors also enjoy a number of potential advantages associated with mezzanine loans. Many investors choose this option for a diversified portfolio, as it offers solid returns without the higher risk level associated with equity. With the option to convert senior debt to equity, mezzanine financing also provides investors with flexibility. Assuming that they never have the option to trigger warrant options, investors still receive higher returns compared to senior debt.
Mezzanine Financing Disadvantages
Compared to equity financing, mezzanine loans carry high interest rates that can be quite costly for the average business. By offering a mezzanine loan, a company also offers investors potential ownership and control over business operations. In addition, a triggered equity option can dilute the value of existing shares, potentially encouraging existing shareholders to sell.
For the average investor, a mezzanine loan represents a risky endeavor in the event of bankruptcy. Mezzanine loans are popular financing options for future projects – and some of these projects may prove to be overambitious. Investors may want to think carefully about what the company plans to do with the money as they assess risk. Due to the prioritization of senior debt, it is possible to lose the entire investment in the event of bankruptcy.
Contact a Business Law Attorney in Arizona
Although online research provides a basic overview of mezzanine marketing, it may be difficult to determine the suitability of this funding option by simply reading an article. After all, the most appropriate funding strategy depends on the unique priorities and needs of each business. For a more targeted approach, consider discussing these priorities and needs alongside a qualified, experienced business law attorney in Arizona. Contact Harrison Law, PLLC at (480) 320-2310 to receive tailored guidance.
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This website and article have been prepared by Harrison Law, PLLC for informational purposes only and does not, and is not intended to, constitute legal or financial advice. The information is not provided in the course of an attorney-client relationship and is not intended to substitute for legal advice from an attorney licensed in your jurisdiction.
