Weighing the risks vs. rewards of a mezzanine loan

To say that most small to midsize businesses have at least considered taking out a loan this year would probably be an understatement. The economic impact of the COVID-19 pandemic has lowered many companies’ revenue but may have also opened opportunities for others to expand or pivot into more profitable areas.

If your company needs working capital to grow, rather than simply survive, you might want to consider a mezzanine loan. These arrangements offer relatively quick access to substantial funding but with risks that you should fully understand before signing on the dotted line.

Equity on the table

Mezzanine financing works by layering a junior loan on top of a senior (or primary) loan. It combines aspects of senior secured debt from a bank and equity-based financing obtained from direct investors. Sources of mezzanine financing can include private equity groups, mutual funds, insurance companies and buyout firms.

Unlike bank loans, mezzanine debt typically is unsecured by the borrower’s assets or has liens subordinate to other lenders. So, the cost of obtaining financing is higher than that of a senior loan.

However, the cost generally is lower than what’s required to acquire funding purely from equity investment. Yet most mezzanine instruments do enable the lender to participate in the borrowing company’s success — or failure. Generally, the lower your interest rate, the more equity you must offer.

Flexibility at a price

The primary advantage of mezzanine financing is that it can provide capital when you can’t obtain it elsewhere or can’t qualify for the amount you’re looking for. That’s why it’s often referred to as a “bridge” to undertaking ambitious objectives such as a business acquisition or desirable piece of commercial property. But mezzanine loans aren’t necessarily an option of last resort; many companies prefer their flexibility when it comes to negotiating terms.

Naturally, there are drawbacks to consider. In addition to having higher interest rates, mezzanine financing carries with it several other potential disadvantages. Loan covenants can be restrictive. And though some lenders are relatively hands-off, they may retain the right to a significant say in company operations — particularly if you don’t repay the loan in a timely manner.

If you default on the loan, the lender may either sell its stake in your company or transfer that equity to another entity. This means you could suddenly find yourself with a co-owner who you’ve never met or intended to work with.

Mezzanine financing can also make an M&A deal more complicated. It introduces an extra interested party to the negotiation table and can make an already tricky deal that much harder.

Explore all options

Generally, mezzanine loans are best suited for businesses with clear and even aggressive growth plans. Our firm can help you fully explore the tax, financial and strategic implications of any lending arrangement, so you can make the right decision.

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