Business financing can be complex, especially for small and medium-sized businesses. From all the financing means available to businesses, mezzanine debt emerges as one available funding option for acquisitions and buyouts. But it’s important to understand what mezzanine debt is and how it works before considering it as a financing option.
In this article, we’ll explore mezzanine debt, its types, how it works, and examples of how it has been used successfully before.
What Is Mezzanine Debt?
Mezzanine debt is a hybrid form of financing that lies between senior debt and equity. It combines debt and equity financing features, giving businesses more flexibility in their financing options. Mezzanine debt is generally used by companies that need additional capital to fund their growth but don’t want to dilute their ownership or control.
Compared to other types of financing options, mezzanine debt is far riskier but generates higher returns – usually 12% to 20%.
Types of Mezzanine Debt
There are two types of mezzanine debt: unsecured and secured. Unsecured mezzanine debt is not backed by any collateral, and its repayment is based on the business’s success. On the other hand, secured mezzanine debt is backed by collateral, such as assets or property, which can be seized if the business fails to repay the debt. Mezzanine debt also differs in the types of equity included in the debt, including embedded options (stocks, warrants, rights).
How Does Mezzanine Debt Work?
Mezzanine debt is usually structured as a loan, but it also includes an equity component in the form of warrants or options. Warrants give the lender the right to buy equity in the company at a future date and at a predetermined price. Options give the lender the right to buy equity in the company at a future date but at market prices.
The interest rate on mezzanine debt is higher than senior debt but lower than equity. The repayment of mezzanine debt is usually deferred until the senior debt is paid off, allowing the business to prioritize its other financial obligations. Mezzanine debt typically has a maturity of five to seven years.
Examples of Mezzanine Debt
Let’s see a few examples of mezzanine debt to get the whole picture.
Mezzanine Debt Example #1
One notable example of mezzanine debt is the acquisition of the popular fashion brand Jimmy Choo by Labelux in 2011. Labelux used mezzanine financing to acquire the brand, allowing it to preserve its equity and control over the company while providing the necessary capital for growth.
Mezzanine Debt Example #2
Another example of mezzanine debt is the financing of the $26 billion acquisition of Hilton Hotels by the Blackstone Group in 2007. Blackstone used mezzanine debt to finance the transaction, preventing it from diluting its company ownership.
These are two of the most popular examples of the use of mezzanine debt. But these examples don’t give us a conclusive image of how mezzanine debt is used.
Mezzanine Debt Example #3
The final mezzanine debt example is a made-up one for clarification purposes.
Mary owns a successful SaaS startup and is interested in expanding her business by adding new features to her software. However, she lacks the capital to fund the development. So, she decides to use mezzanine debt to finance the expansion.
Mary approaches a mezzanine lender who agrees to provide her with $1 million in financing in exchange for warrants that give the lender the option to buy equity in the company at a later date. With the additional capital, Mary can now fund the development of the new features, which will help her company grow faster.
But she must repay the mezzanine debt lender, so they decide on a 10% yearly repayment. So instead of forking $1 million of her own money, Mary will only pay $100,000 in interest for the mezzanine loan each year.
Mezzanine debt can be a useful financing option for businesses needing additional capital but not wanting to dilute their ownership or control. It offers a flexible form of financing that combines debt and equity financing features. By understanding how mezzanine debt works and its types, businesses can make informed decisions about whether it’s the right financing option for them.
Mezzanine debt is a hybrid between equity and financing and works by giving the lender the right to convert the debt into equity with interest repayments.
Compared to traditional debt financing, mezzanine loans or debt is considered the riskiest financing option and one with the highest interest rates (12% to 20%).
The interest rate for a mezzanine loan is generally between 12% and 20%. It’s not uncommon for the interest rate to go as high as 30%.