Mezzanine debt offers several benefits including a greater amount of funding, longer terms, back-ended payments, and the ability to retain control over the company. However, a clear advantage of mezzanine debt is the flexibility it offers borrowers. The mezzanine can be customized to the specific capital need you may have. This flexibility makes it a creative financing option for small and mid-market companies that have moved beyond the start-up status but do not yet have the capacity to finance big growth moves themselves or via traditional lending arrangements.
Mezzanine debt allows for greater flexibility through its highly flexible structures. Opting for mezzanine debt offers a mid-market company with customized solutions to structure coupon, amortization, and covenants that accommodate the specific cash flow requirements of the business. It is best used when there is a follow-on need for additional capital when subsequent acquisitions are part of the future growth plan.
Greater flexibility through mezzanine debt structures
In most mezzanine deals, the specific objectives of the company and the existing capital structure in place determine the kind of structure to be used. While the basic forms used in most mezzanine financings are subordinated notes and additional return upside for the lender, a mezzanine deal is typically made up of any one or a combination of the following:
Cash interest: This involves a periodic payment of cash based on a percentage of the outstanding balance of the mezzanine financing. Such an interest rate is usually fixed throughout the term of the loan,
Upfront Fees: This involves payment of a closing fee to the mezzanine debt lender. This is usually in the 1% to 2% range on the amount of the loan.
Additional Return Upside: Some but not all mezzanine deals involve a small return kicker called a warrant. This allows the lender to receive a small additional return based on the future performance of the company. This is in addition to in payment of cash interest and PIK interest. The valuation methodology for this return is clearly defined when the deal is closed. This additional return mechanism is useful for aligning the interest of the business owner and the lender as to the future value of the company.
PIK interest: The short form for Payable-In-Kind interest, PIK is a periodic form of payment in which the interest payment is not paid in cash but rather by increasing the principal amount of the loan in the amount of the interest. The PIK interest amount is usually 2% and is in addition to the cash interest payment.