Small and medium-sized businesses that have demonstrated profitability have a range of financing options. Some companies opt to raise funds by issuing bonds, while others partner with equity investors. Though traditional bank lending is an option, this alternative can be more challenging given today’s economic conditions. One choice that offers flexibility while encouraging growth is subordinated debt, or mezzanine financing.
Offered by a specialized lender, mezzanine loans are a combination of debt and equity financing. A business is able to borrow funds that are needed for expansion. The remaining funds are raised by selling company stock to the lender.
Subordinated loans are paid off after senior debt, or traditional financing has been repaid. They have a higher risk because there is no collateral to secure the loan. As a result, the interest rate for these loans is high, in the 20 to 30 percent range.
This type of financing is desirable, because it enables the business to take advantage of the aspects of conventional borrowing and equity financing under the terms of one loan. Here are some additional advantages:
Tax Benefits – Though mezzanine financing usually requires a higher rate, the interest is tax-deductible. With higher corporate tax rates, the overall tax rate is significantly lower.
Business Control – Many financing arrangements require that business owners relinquish a portion of control of their business to the lending party. Though a mezzanine lender may request a voting seat on the board, they do not require the business owner to give up management of the firm’s day-to-day operations. In addition, the management team is allowed to remain in place. As long as the company performs as predicted, the lender will not interfere with the running of the business.
Flexible Financing – Mezzanine financing comes behind senior debt, so business owners have more flexibility over its terms. Since equity is offered as part of the loan, collateral is not required to guarantee the loan. Therefore, the company is able to use capital to access valuable assets such as facilities and equipment to expand the business. These loans also offer flexible amortization schedules, coupon rates and time periods, since the lender is primarily interested in its equity position in the company.
Extended Timeframe – Due to the unique relationship between the business owner and the lender, mezzanine loans usually span an extended time frame. This gives business owners an opportunity to focus on growth and expansion rather than loan repayment over a traditional two or three year time period.
Though not highly publicized, mezzanine financing can be found in deals ranging from private equity buyouts to real estate developments. As you grow your business, it might be worth seeing if a subordinated loan product is appropriate for your needs.