Most entrepreneurs know about the traditional types of funding: debt or equity. But did you know there’s something that combines the two? It’s broadly referred to as mezzanine financing. In this post, I’ll quickly review of debt and equity funding, then explain how mezzanine financing is a hybrid of both — and why it could be right for you and your company.
Commonly from banks and institutions, debt funding is called by many names – senior loans, security-based lending, asset line of credit. All are referring to one over-arching concept: capital a company receives in exchange for interest. There are several pros to getting a loan:
- Maintain control (as opposed to having investors tell you what to do)
- Flexible repayment or refinancing schedules
- Low fixed rate
However, a bank loan has its drawbacks as well:
- Bank loans require assets as collateral
- Funding is capped based on earnings
- Decreased cash flow due to debt servicing
- Debt (often in the form of the collateral) is owed even if the company fails
- Good credit is required
On the other hand, a business owner can also consider equity funding—also called venture capital, angel investors, seed funding, or series A-C. These are all private investments where the company receives funds in exchange for an equity stake in that company. Just like debt funding, equity funding also has its advantages:
- Opportunity to take on a strategic partner in a similar industry
- No debt servicing required
- No repayment if the company fails
But there are disadvantages as well, such as:
- Investors can be hard to find and acquire
- Investors often want an active role
- Equity funding sacrifices future earnings
Mezzanine financing is that middle ground between debt and equity funding, hence the term “mezzanine.” It combines some of the features described above, often considered a hybrid of the two.
What is Mezzanine Financing?
Mezzanine funding enables you to maximize capital while minimizing dilution and control. There are many types, such as subordinated debt, convertible notes, and redeemable preferred stock. While mezzanine financing can take many forms, it does share a few common traits:
- There is usually a guaranteed return at a higher-than-prime interest rate (typically 15-25% or more)
- It’s backed, but by equity and not tangible assets
- It can typically be bought out
- The interest is tax deductible
- Takes a junior position to senior debt and therefore is not paid back if the company fails and there are no assets to offer in return
- Flexible payment terms
- Can often be converted to equity if the lender opts to
Mezzanine financing supplements loans and equity funding. It can bridge the gap when there are no more leverage-able assets and no more equity stake to sacrifice. The ideal breakdown of financing consists of mostly debt funding, supplemented by some mezzanine funding and a little bit of equity funding (visualize a pyramid with debt funding as the base). Here are common breakdown percentages:
- 30-60% debt funding
- 20-30% mezzanine funding
- 20-30% equity funding
Case Study 1: Real Estate
Real estate financing is a common example of mezzanine funding. Banks often only finance up to 40% of the project cost. The solution? A “gap loan” at a higher interest rate that can make up the difference!
Here’s an example: For a $28M real estate project, a bank would be willing to finance $16.8M. That means the developer would need to come up with $11.2M to make the project happen, and a combination of mezzanine funding and owner investment can bridge the gap:
- Bank financing: $16.8M
- Mezzanine financing: $5.2M
- Developer: $6M
While the bank loan requires monthly payments, the mezzanine loan requires an annual interest-only payment with a lump sum payout at the end of the 5-year term.
Case Study 2: Leveraged Acquisition
Another time that mezzanine financing might be wise is an acquisition in which the company’s assets aren’t enough to back the funding required.
For example, let’s say you want to buy a company being offered for $1M. Based on the company’s assets, a bank would offer $600,000 in secured funding, and you, as the buyer, have $200,000, leaving a $200,000 shortfall. In this scenario, you could consider equity funding, but unless you can significantly increase earnings, the investor will want more equity than you would want to offer.
In the scenario listed below, the $200,000 is raised via a convertible note.
- Secured Loan: $600K
- Owner Investment: $200K
- Mezzanine Financing: $200K
The terms of the convertible note are a 5-year term with an interest-only payment made at the end of each year. At the end of the term, the lender has an option to convert that debt into equity at a discount or request a lump sum payoff, as illustrated in the assumptions below.
When converted to equity, the lender receives a 20% discount, meaning the $200,000 is the equivalent of $240,000.
As shown, the $240,000 is worth 16% equity in the company. On the balance sheet, the long-term liability moves to paid-in capital, but at $200,000 (the $40,000 extra is used for value only).
Does mezzanine financing make a little more sense now? While we at Masterplans don’t offer financing, we do create financial models for clients as part of our world-class business plans, and we’re always happy to talk to you about mezzanine financing – or debt and/or equity financing. Get in touch today!