The growth stage of a new venture that is late in the “Early Stage” continues into expansion stages that typically require mezzanine or bridge funding. This form of funding is made up of convertible debt or preferred shares, which are more costly and provide investors certain rights over the holders of common equity. Mezzanine financing is typically known as bridge financing because it finances the growth of expanding companies prior to an IPO.
Companies in the later stages of development generally have fully vetted business models, put in place a broad, multi-functional team, commercialized their product, and achieved reasonable sales momentum. The next step forward is to find additional financing to scale the company. The objective of the mezzanine funding is to add the fuel necessary to significantly accelerate the growth curve of the company.
What is Mezzanine Financing?
Mezzanine financing is a layer of financing that fills the gap between senior debt and equity in a company. It can be structured either as preferred stock, Preferred Shares. Preferred shares (preferred stock, preference shares) are the class of stock ownership in a corporation that has a priority claim on the company’s assets over common stock shares. The shares are more senior than common stock but are more junior relative to debt, such as bonds. or as unsecured debt, and it provides investors with an option to convert to equity interest. Mezzanine financing is usually used to fund growth prospects, such as acquisitions and expansion of the business.
A gap between senior debt and equity financing exists due to the following common reasons:
Inventory, accounts receivable, Accounts Receivable Accounts Receivable (AR) represents the credit sales of a business, which have not yet been collected from its customers.
There is a substantial volume of intangible assets recorded on the balance sheets.
To address the rise in defaults and regulatory pressure, banks impose limits on the total debt that a business can acquire.
Mezzanine investors can earn returns from the following available sources:
1. Cash interest
Based on the portion of the outstanding mezzanine funding balance, investors receive cash periodically. The interest rate may either be set or may fluctuate over the loan period.
2. Payment in Kind (PIK) interest
It is also a periodic method of payment. However, the interest amount is not paid in cash. Instead, it is added to the principal sum of the security, and the total amount is paid at the end of the loan period. For example, a $50 million bond with a 10% PIK interest rate will amount to $55 million at the end of the period, and there will be no cash interest payment.
Similar to a convertible bond, mezzanine financing often includes an equity interest in the form of a conversion feature or warrant. Usually, the PIK interest or the cash interest follows the ownership portion of the securities.
4. Participation payout
In place of equity, investors may take a return on equity in the form of a percentage of the company’s performance as measured by net sales or EBITDAEBITDAEBITDA or Earnings Before Interest, Tax, Depreciation, Amortization is a company's profits before any of these net deductions are made. EBITDA focuses on the operating decisions of a business because it looks at the business’ profitability from core operations before the impact of capital structure. Formula, examples, or profit.
5. Arrangement fee
Mezzanine investors are also required to be paid an arrangement fee upon closing the transaction.
Benefits of Mezzanine Financing
To the Issuer
1. Increase in total capital
Mezzanine financing can help a company secure more capital and circumvent the under-capitalization of the business. The interest payment on mezzanine funding is also tax-deductible.
2. Reduction of capital cost and an increase in equity returns
Equity is the costliest source of capital, and it dilutes the current shareholders. Therefore, mezzanine debt may be an attractive alternative for accessing much-needed capital. Companies use an appropriate combination of senior debt, mezzanine debt, and equity to reduce the true cost of capital and increase asset returns.
To the Investor
1. Attractive and safe investment
The mezzanine investor enjoys the advantages of equity investment in the form of high returns and a diverse portfolio. In the case where the borrowing company becomes successful, the mezzanine investor can exercise the equity option and receive the benefits.
In addition, even in the worst case, the mezzanine investor gets at least the interest payment. The interest received for mezzanine financing outperforms the one received against traditional financing.
2. Warrant option
Mezzanine financing often includes warrants or convertible equity options that a mezzanine investor can exercise to earn a stake in the company. The rights can be exercised at a given date or the occurrence of any specific event, as outlined in the agreement.
Mezzanine Financing Limitations
For the Issuer
1. Probability of failure
Mezzanine financing, though readily available, demands high interest rates. In case the project fails to take off, the creditor will need to pay back the extremely costly loan.
2. Potential loss of control and freedom
When creditors take mezzanine debt, they sacrifice freedom and control, as conversion to equity is always a possibility. Moreover, the equity option, when exercised, results in the dilution of EPS, triggering a negative reaction from existing shareholders.
For the Investor
1. High risk
Mezzanine financing is provided without collateral, and the investment is mostly made in high-yield but risky, projects. Thus, investors are exposed to the risk of losing the investment in case the company goes bankrupt.
2. Long time-period for return on investments
Companies usually seek mezzanine financing for the growth or expansion process. Such ventures require some time before they can produce returns. Mezzanine financing is not intended for investors who are looking to make quick money. It is why mezzanine financing agreements specify the interest commencements after a period, not immediately.
It helps a business secure more capital, lower the cost of capital, increase the rate of return, and save tax on interest payments.
Mezzanine financing includes a convertible option or warrant that provides investors with a right to earn a stake in the business. It, however, results in the existing owners being diluted by the issuance of additional shares.