Mezzanine Financing
Mezzanine financing is a culmination of debt financing, such as a business loan from a bank, and equity financing, like the number of money shareholders, would receive after liquidation. It is a subordinated loan, denoting that the debt can be converted to equity after defaulting after a senior debt has been paid off. This type of financing is much more costly than usual loans, with interest rates ranging from 15% to 30%, because it is high risk. Nevertheless, returns are high, and tax is deductible.
What is Mezzanine Financing?
As mentioned, mezzanine financing has elements from debt and equity financing. In essence, it sits below senior debt, which has higher priority so has to be repaid first, and above preferred equity, which is of lower priority but higher risk. If a company defaulted and had to liquidise its assets to pay off its shareholders, senior debt would be the first charge because it is secured by collateral such as property. Only after this would the mezzanine debt be paid off, making it a second charge.
Mezzanine financing is so popular with businesses because it helps to significantly increase capital, which a traditional loan from the bank would not do. This way, businesses have more financial aid and can afford to operate and begin new projects without limitations from lenders. Banks view mezzanine as equity and are more likely to lend you a larger loan, increasing returns on equity and cash flow.
How Does Mezzanine Financing Work?
To decide whether mezzanine financing is the best option for your business, you must first understand the process. The first step is calculating the loan size you wish to secure; mezzanine loans are designed for large or industrial businesses and often cost millions. After this, you must search for a mezzanine lender that will give you a partial amount of this price, your assets, and a bank that will lend you the rest. Once a suitable interest rate has been agreed upon, and the payment date is established (usually up to five years), you can receive your loan. An example best demonstrates this.
A business needs £50 million to buy a rival company. However, it does not have this amount spare and is looking to borrow money from a lender. A shareholder can provide £10 million, and the bank has agreed to lend £25 million, but no more. A mezzanine lender must then be found to connect the business to their goal and loan the remaining £15 million at a 15% interest rate. Consequently, the business will succeed in buying the company. The returns on this deal would be high, the interest on the loan would be tax-deductible, and the business would have been successful in its development opportunity, allowing them to grow.
Advantages and Disadvantages of Mezzanine Financing
Mezzanine financing is targeted at large businesses looking for substantial loans to aid their business ventures financially, allowing them to expand. They are therefore advantageous, but the drawbacks should still be considered.
The main benefit of mezzanine financing is the capital increase. This is because banks see this type of funding as equity, and therefore less money needs to be borrowed from other lenders or your pocket. As a result, the business has more money available and can expand faster and improve its revenue. Additionally, the interest in mezzanine lending is tax-deductible. Businesses can subtract it from their income and do not have to pay tax, which is especially useful when considering the high-interest rates that deter businesses from mezzanine financing at first.
Whilst there are multiple advantages, disadvantages must also be considered to gain a complete understanding. A crucial drawback is that the flexibility to run your business and make your own financial decisions is at risk because an outstanding debt to equity ratio must be maintained.
There are certain limitations as to how you can spend your cash flow. Furthermore, if you fail to pay the lender back, they can take equity as compensation. It should be noted that mezzanine financing has one of the highest interest rates compared to other loans. Whether the business will be able to repay the funding is essential to discuss before applying.
Mezzanine Financing – To Conclude
In conclusion, mezzanine financing is an intermediate between debt and equity financing. It is used when large companies require financial assistance to take advantage of expensive yet rewarding businesses opportunities. This type of funding is high interest and usually unsecured, but the interest is tax-deductible, and returns are high, making it a viable option for willing businesses.
Funding options discuss obtaining business loans with bad credit in more detail here.
Other useful links about loans:
Enterprise Finance Guarantees Loans
Asset-Based Lending
Bridging Loans
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