It’s important for a growing startup to attract investors and maintain adequate financing. Startups should understand different types of financing options available, specifically, the most appropriate types of financing to support different stages of business growth. One type of financing for startups warrants mention: mezzanine financing.
Startups sometimes pursue mezzanine financing. This is a relatively high-risk form of debt, but under certain conditions, can help startups. It is sometimes useful for later stage startups with steady profits.
Characteristics of Mezzanine Financing
Although often referred to as mezzanine loans or mezzanine debt, this alternative financing arrangement shares characteristics of both debt and equity. Its hybrid nature makes it an appealing financing option.
Mezzanine debt historically has come with high leverage and inflexible terms. It has evolved in recent years. Many small and medium sized companies find it provides more flexible terms that traditional senior debt and avoids the expensive, dilutive qualities of equity.
Mezzanine loans are a junior form of debt. Unlike senior secured loans, they are typically not secured. Sometimes mezzanine loans include equity warrants. This equity component can add versatility and increase the potential return on investment.
Mezzanine loan agreements often include provisions that limit later issuance of debt that is senior to existing loans. These loan covenant restrictions protect existing lenders.
Unique repayment structures often apply to mezzanine financing. For example, mezzanine loans may adopt an interest-only payment method. A typical loan requires payment of a combination of interest and the original principal amount according to a periodic payment schedule.
Mezzanine loans may require interest-only payments until the end of the loan payment period. Interest-only payments often result in smaller periodic loan payments. Interest rate structures can be part fixed and part variable.
This frees up cash to invest in current growth of the startup. In addition, at the end of the loan period, the debtor must repay the full principal amount of the loan.
Debt Finance Waterfall
A waterfall structure helps compare the relative risk of different tranches of debt and equity in a company’s capital structure. The various forms of debt or equity held by the company are depicted in this waterfall structure. Risk is measured as the likelihood a creditor will be paid back in the event of bankruptcy or liquidation of the company.
Creditors with the highest seniority claims are toward the top while lower priority claims fall toward the bottom. Senior debt typically has the highest priority, while subordinated debt and mezzanine debt have lower rights of collection upon asset liquidation. Mezzanine debt is one of the highest-risk debt types but is senior to equity. Among all claims, equity holders (or preferred stock and common stockholders), have the lowest priority to recover assets.
Higher risk can also equate to higher returns. Mezzanine loans can generate returns of 12-20% per year. This is far more than other forms of lower risk debt. Mezzanine financing can help fill the financing gap between senior debt and equity.
The embedded options, warrants, and other types of equity included with the debt provide the flexibility to convert the debt into stock. The equity conversion option gives companies greater flexibility to manage their debt holdings and deal with bondholders.
Mezzanine financing is often associated with mergers and acquisitions and leveraged buyouts. It is also common in commercial real estate transactions. Developers may use it to increase leverage and reduce equity exposure. By funding a portion of a project with a mezzanine loan, developers may be able to free up capital for other uses.
Mezzanine financing can be a good “in-between” option for companies looking for an alternative between raising equity or debt. Startups should evaluate their circumstances and decide if it is a viable and desirable form of financing.