Mezzanine financing is a type of small business funding that combines elements of regular debt, like interest payments, collateral, or requiring personal guarantees, with elements of equity funding when the financing can be converted into ownership of the company.
Businesses normally use mezzanine financing when traditional and alternative lenders won’t approve them for another small business loan, or the new loan will not offer enough funding. Small business owners also use mezzanine financing when they don’t want to give up a high percentage of future profits, as equity investors are sometimes involved with this type of funding and each one becomes a partial owner of the business.
The Three Types of Mezzanine Financing
There are three types of mezzanine financing, including subordinated debt, convertible debt, and preferred stock.
Subordinated debt is like a regular business loan, but lenders charge higher interest rates since they’re taking on more risk, because “subordinated” means the lender is lower in line to recoup any losses in case of a default. A second mortgage is an example of subordinated debt where real estate is the collateral, but the subordinate lender gets paid only after the first mortgage is paid in full.
Convertible debt gives lenders an option to convert the business loan into equity ownership of the company where they will be paid from profits. Convertible debt starts with monthly payments plus interest like a regular business loan. If the lender chooses to “convert,” they buy shares in the company at an agreed-upon price; the company no longer pays the debt; and the lender becomes a part owner and gets paid from profits.
Redeemable preferred stock is equity shares, where the company can buy them back at an agreed-upon price. This works by selling shares of the company to equity investors and paying them a dividend per share, which is usually a percentage of the price per share. The company also pays these investors a share of all future profits unless the company “redeems” the shares (i.e., they buy them back at an agreed-upon price, which is usually higher than the original investment).
If you’re considering new funding for your business, here’s when mezzanine financing can make sense and when alternatives may be a better choice.
When Mezzanine Financing Works for Small Business
Mezzanine financing works well for small business when:
- You cannot get a traditional business loan.
- A traditional loan isn’t enough to meet your needs.
- Interest rates or dividends are lower, and you’re willing to give up some upside.
You Cannot Get a Traditional Small Business Loan
When you can’t get a traditional business loan because your company doesn’t have enough collateral to make you a low-risk borrower, mezzanine financing can make sense. The higher interest rate you’ll pay offsets the lender’s higher risk.
Pro-Tip: Check your existing loan contracts for clauses limiting debt service coverage or other debt ratios. Your original lenders could claim default if payments from new mezzanine financing lower your ratios below contract thresholds.
A Traditional Loan Isn’t Enough to Cover Your Needs
Mezzanine financing lets you attract lenders and investors that aren’t restricted by loan-to-value or other regulatory requirements, because it gives them higher returns and lets them participate in potential upside. It works well when a traditional loan isn’t big enough to cover your full needs.
One example is loan-to-value restrictions on a real estate loan. If you need $1.5 million to renovate an office park that’s worth $1 million right now, but you estimate it will be worth $3.5 million after renovations, traditional lenders might offer only $800,000 because they can’t take a risk on what the future value “could” be. A mezzanine financing lender that specializes in real estate investments may see the value and finance your project.
Interest Rates or Dividends Are Lower and You’re Willing to Give Up Some Upside
When the interest rate on convertible debt, or the dividend rate on preferred stock, is lower than that of a traditional loan, mezzanine financing works well to minimize the hit to near-term cash flow in exchange for potential future profits. Buying a competitor or expanding internationally are two examples where these types of mezzanine financing could work better than traditional business loans.
Convertible mezzanine lenders can offer lower rates because the option to convert their debt into ownership of the company gives them a nice return on investment if you succeed. The lower rate you pay on the debt in the near term keeps your costs lower and lets you focus on other priorities, like cutting excess costs while integrating a competitor’s business or making sure an international expansion runs smoothly. You’ll have to share some of the profits with the lender if they convert to equity after you succeed, but it will be a slice of a much bigger pie.
With redeemable preferred stock, you’ll get funding from equity investors and pay a dividend instead of interest. Then you can buy back the shares based on the contract price if future profits look like they’ll be higher than you thought.
Times to Avoid Mezzanine Financing
The times to avoid mezzanine financing include:
- You have uncertain or unstable cash flows.
- There is a low return on investment or uncertainty of success.
Uncertain or Unstable Cash Flows
Avoid mezzanine financing when you have uncertain or unstable cash flows and don’t have assets that you can sell in a pinch. High seasonal fluctuations, untested new products or markets, or the economy going into a recession are good examples to consider.
Higher rates on subordinated mezzanine debt mean higher interest payments, and you could default on the loan if you don’t have the cash flow to cover them. If that happens and the lender calls the loan due, you’d have to sell other assets to pay them back. If you don’t have other assets because they’re tied up as collateral on other loans, you could go into default on traditional debt and end up going into bankruptcy.
Low Return on Investment or Uncertainty of Success
Avoid mezzanine financing when you expect a low return on investment (ROI) or if there’s a lot of uncertainty regarding a venture’s success. With subordinated debt, the higher interest rates will take up too much of your profit margin on low ROI projects. With redeemable preferred stock, you might not have made enough profit to buy back the shares at the contractual price and could lose money on the investment.
Alternatives to Mezzanine Financing
The alternatives to mezzanine financing are debt or equity financing with debt being a traditional business loan and equity being when you sell shares of your company in exchange for financing.
If traditional business debt or equity financing won’t work, these other alternatives might:
- Refinancing existing debt with separate loan types
- Loaning personal funds to your company
- Using a 401(k) Rollover as a Business Startup (ROBS)
Refinancing Existing Debt With Separate Loan Types
Refinancing existing debt using multiple different types of loans can help you overcome issues with loan amounts and limited collateral. A logistics company with an existing commercial business term loan but limited assets could refinance and expand operations by doing a cash-out refi with the existing lender, use the cash as a down payment for an SBA 504 loan to buy new real estate, and then use equipment financing loans for new trucks.
Loaning Personal Funds to Your Company
Loaning personal funds to your company is another alternative to mezzanine financing. Beyond your own funds, you could also use funds from an existing home equity line of credit (HELOC), which you may have been using to renovate your house or cover other personal expenses.
Using a 401(k) Rollover as Business Startup
401(k) rollover as a business startup uses your 401(k) plan to purchase stock in your private business, making it a good alternative to mezzanine financing because your 401(k) acts as the “investor,” so you’re paying future profits to yourself. The IRS has strict rules on this, so consult a tax professional and whoever manages your retirement plan if you’re considering it.
By combining elements of both debt and equity, mezzanine financing opens your funding options when you can’t get a traditional small business loan or don’t want to give up an indefinite share of future profits to new equity investors. It’s a great option when your situation won’t allow you to qualify for a business loan, but your company’s growth is highly likely. For those times when it doesn’t make sense, alternatives like refinancing can fill the funding need.
National Funding does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only. You should consult your own tax, legal and accounting advisors.
