Whether you’re planning on going for mezzanine financing or you’ve just heard about it and didn’t know what it was, this article will teach you all about it. We’ve also included an example, to make matters easier to understand.
What Is Mezzanine Financing?
In simple terms, mezzanine financing is a type of funding. It got its name from the fact that it stands somewhere between debt and equity financings, both used by businesses.
Its purpose is to provide companies with cash in case they decide they want to grow, go for a leveraged buyout or try corporate restructuring. When it comes to mezzanine financing, the borrower himself is not held publicly. Therefore, if he needs more cash for his operations and transactions, he cannot access the public markets. This cash source is not available to him.
As a consequence, this is the reason why mezzanine financing exists. As far as the lenders go, they are usually smaller financial institutions which specialize in this type of debt, rather than the more traditional banks.
What Do You Need to Know About Mezzanine Financing?
Here is how mezzanine financing is structured.
- It’s a type of convertible debt. Therefore, the lender can always swap it for stocks belonging to the company, if their price rises and he considers this to be a smart move.
- Mezzanine financing is also a type of debt which has a large number of warrants attached to it. They also permit the lender to buy company stocks, in case their price goes up.
- It’s a preferred stock. Therefore, it earns dividends and has particular voting rights. It can also convert to common stock as well as a series of other special features.
What you must gather from these characteristics is that the lender wants to be involved in some way in any gains that might subsequently come from the borrower’s stock. At the same time, the lender wants to avoid the declines in the value of said stocks, so that he doesn’t end up losing money.
If we structure it as a debt, then mezzanine financing will be junior in comparison with the debt belonging to the company’s traditional lenders, such as the bank. The latter issues lines of credit and long-term loans. In laymen’s terms, this means that, in case the borrowing company has cash flow problems, it will prioritize its debts. The company will first pay off its senior loans, meaning the ones coming from banks, and then its junior debts.
The latter will be paid from the residual cash that is left available after the company pays off the senior debts from banks and creditors.
This situation means that the lenders of mezzanine financings are in a quite unfavorable and risky position. Therefore, they typically ask for very high returns, ranging between 20% and 30% per annum. Apart from that, they can also charge you an arrangement fee up front, which will also be quite high.
The 20 and 30 percent interest fees, as well as the high upfront, are the reason why mezzanine financing lenders want to take some precautionary measures when it comes to getting their money back. It would be far-fetched to believe that companies can pay such a large interest every month. Therefore, the lenders apply the conversion method, where they secure themselves by asking for the possibility to get company stocks.
As you can well see, mezzanine financing can become the source of a great deal of money. It can also end your cash flow problems. However, it does have downsides as well, and you should be aware of them.
- The financial institution which lent you the money can impose covenants on you so. Therefore, they can protect their investment and, of course, their money.
- If the lender goes for the options of taking stocks instead of the money you owe him, then he might become a large shareholder in your company. Therefore, he will be able to influence your decisions.
- Mezzanine financing is one of the most expensive options as far as debt financing goes.
- It will only become available to you after the lender has conducted a prolonged investigation on your company. Therefore, it is by no means fast money.
Mezzanine Financing – an Example
Let’s say, for the sake of argument, that you are willing to buy a small coffee shop in your town and start a business. As far as operating income goes, this coffee shops earns an estimated $20, 000 every year. The current owners are willing to let it go for $1 million. Evidently, you don’t have this kind of money just lying around and waiting for you to invest them in coffee shops.
Therefore, you find a senior lender, such as a bank, which can finance $600, 000 of this purchase at the rate of 8 percent per annum. You are the equity investor, and you will contribute the rest of the $400, 000. Knowing all these details, we can calculate the rate of your return.
Out of the $200, 000 it makes every year, we have to subtract the $48, 000 you will pay in interest to the senior lender. Therefore, we get a profit of $152, 000 before taxes. Let’s say that the profit tax is 35 percent. Therefore, your profit after you have paid the taxes will be of $98, 800 annually, which is, in fact, pretty good!
Still, what if you could lower your equity investment? Let’s say that you can find a second lender, a junior one, which will add more leverage? Evidently, this will be a mezzanine lender, who can give you $200, 000 at a 15 percent rate.
As a consequence, here is how your new capital structure looks like. Your senior lender is giving you $600, 000 at eight percent per year, the mezzanine lender brought in $200, 000 at 15 percent, and you contributed $200, 000.
Now, let’s do the math. The must subtract the very same $48, 000 that you pay in interest toward your senior lender. To that, we add $30, 000 which you pay to the mezzanine lender. Therefore, your profits before tax have now taken a plunge, going to $122, 000. Next are the taxes themselves, of course, which take you even lower, down to $79, 300 in profits every year.
The con here is the fact that you will make less profit, seeing as you now have a second lender to give interest to. However, the pro is that you have to put down less money yourself in equity. The result is that, even though your annum profit takes a dive, your return on equity will rise. In the case of our coffee shop example, from 24.7 percent to 39.7 percent every year.
In the end, after examining all the cold, hard data and looking at the math in the example, it is up to you which option you choose. As you can well see, mezzanine financing has its ups and downs. It all depends on the angle from which you look at things.
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