Mezzanine financing can be a great financing tool for companies that are in a transitional phase of growth environment, seeking capital for expansion or acquisitions without diluting ownership significantly.
It is a viable option for businesses that have outgrown the funding capabilities of traditional bank loans, as well as those looking to bridge financing gaps or fund growth initiatives such as expanding operations or entering new markets.
However, it is not always the best option, especially in certain circumstances. In this article, we will discuss some of the main mezzanine financing alternatives for businesses, and in what cases you should consider one of them.
What Is Mezzanine Financing?
Mezzanine financing is a hybrid form of capital, positioned between senior debt and equity. It is used typically by established companies for growth or acquisitions, and it includes debt with rights to convert into equity.
This provides more flexibility but is also associated with elevated costs – the loan comes with high interest rates, but if you can’t pay it back or you violate a contractual obligation, the lender might get a share of your company instead.
When Is Mezzanine Financing Not The Best Option?
Before we discuss the most common mezzanine financing alternatives for businesses, it is important to understand in what situations mezzanine financing may not be the best option.
Let’s take a quick look:
- If your company is at an early development stage – Companies at earlier stages of development, such as startups, typically lack the stable cash flows and operational history that mezzanine lenders ask for. They are considered high-risk as they may struggle to meet interest payments and stringent terms.
- If you want to avoid equity dilution – On other occasions, you may opt to look for mezzanine financing alternatives if you want to avoid equity dilution. Since mezzanine financing often includes equity components such as warrants or conversion features, it may not be the best option in that case.
- If you don’t have enough cash flow – Another situation in which mezzanine financing may not be the most suitable option for your business is if your cash flow is insufficient to cover the high-interest payments and principal repayment of the loan. In this case, this form of financing can strain your resources too much.
- If you are sensitive to high financing costs – since mezzanine loans tend to be more expensive than traditional debt (in the event of a bankruptcy or liquidation, mezzanine debt holders are paid after senior debt holders, making them riskier), they may not be an ideal option if you are sensitive to high financing costs.
- If you don’t want to be bound by financial covenants – if you prefer not to be bound by the financial covenants and potential equity participation that accompany mezzanine financing, you may have to look for less restrictive mezzanine financing alternatives.
7 Mezzanine Financing Alternatives For Businesses
Now that we have a better perspective on the situations in which mezzanine financing may not be the most suitable option, let’s take a look at the most common mezzanine financing alternatives you can opt for:
1. Venture debt
If you are evaluating alternatives to mezzanine financing, another option that you can consider is venture debt. This type of funding is designed specifically for venture-backed companies that may lack the assets or cash flow for traditional loans.
Venture debt often includes warrants for company equity, offering a balance between debt and equity benefits.
Pros:
- Doesn’t require significant dilution of ownership
- It’s a faster way to secure funding (compared with equity financing)
- Can be less costly in the long run due to less dilution
Cons:
- Unlike equity, it must be repaid with interest
- Includes warrants, giving lenders the right to purchase equity
- May come with financial covenants or require collateral
2. Asset-Based Lending (ABL)
Our list of mezzanine financing alternatives continues with asset-based lending, also known as ABL. In this type of financing, loans are provided based on the value of collateralized assets, such as inventory, equipment, or accounts receivable.
Asset-based lending offers you a way to obtain liquidity by securing loans against your existing assets, making it especially suitable for companies with significant physical assets but perhaps less consistent cash flow.
Pros:
- Provides immediate cash flow based on asset value
- Can increase with the growth of the assets, potentially offering more funding
- Can be a good option if you have a weaker credit profile due to less stringent criteria
Cons:
- There is a risk of losing the collateral assets if you default on the loan
- Comes with various costs, from due diligence fees to appraisal fees
- Setting an ABL arrangement can be lengthy and complex
3. Private Equity
Among the most common mezzanine financing alternatives is private equity, which involves investment funds that directly invest in private companies or buy out public companies to delist them from stock exchanges.
This type of investment is usually attractive for businesses seeking substantial capital for growth or restructuring.
Pros:
- Provides more substantial funds compared with other methods
- Private equity firms can bring extensive managerial and strategic experience
- Encourages sustainable growth strategies due to its long-term nature
Cons:
- Often involves giving up significant equity stakes
- It’s associated with high ROI expectations
- Leveraged buyouts may burden the company with high debt levels
4. Convertible Debt
Convertible debt is a type of loan that can be converted into equity, typically at the discretion of the investor, under predefined conditions.
It combines the features of both debt and equity financing, offering companies a less dilutive initial option for raising capital while providing investors with an opportunity for equity participation if the company grows significantly.
Pros:
- Allows you to delay equity dilution until a later financing round
- The process can be faster compared to straight equity deals
- Interest on convertible notes is usually tax-deductible
Cons:
- Requires interest payments, which can strain cash flows
- Conversion terms may not always be favorable to existing owners
- It’s associated with a higher maturity risk which can lead to financial distress
5. Crowdfunding
Among the most common mezzanine financing alternatives for your business is crowdfunding, which refers to a form of raising capital through collective efforts from a large number of people – typically via online platforms.
This method allows individuals to invest small amounts of money in exchange for products, equity, or debt in startups or projects.
Pros:
- Allows to validate the market without committing significant resources
- Supporters often become advocates for the product or company
- Doesn’t require any collateral
Cons:
- The full amount must be raised in order to receive any funds
- Public idea sharing may pose a risk to intellectual property
- Crowdfunding platforms charge fees on the funds raised
6. Sub Debt
Speaking of the most common mezzanine financing alternatives for your business, probably the best option that you can opt for is sub debt.
It’s considered riskier for lenders compared to senior debt because in the event of insolvency, senior debt holders are paid back first before subordinated debt holders receive any repayment.
Pros:
- Provides additional access to capital without diluting existing equity
- It’s generally cheaper than equity financing despite the higher interest rate
- Offers more flexibility than senior debt, including terms and repayment schedules
Cons:
- It’s riskier for lenders, which can result in a higher interest rate
- Some subordinated debt agreements may include equity-like features
- Lenders of sub debt may impose more restrictive terms compared to senior debt
Applying for Sub Debt with National Business Capital
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Frequently Asked Questions
Senior debt has priority over other debts for repayment in a bankruptcy scenario, making it less risky and often featuring lower interest rates. Subordinated debt, in contrast, is repaid after all senior obligations have been met, carrying higher risk and thus higher interest rates.
The typical interest rates for senior debt vary based on economic conditions, creditworthiness of the borrower, and market rates. Generally, rates are a few percentage points above the prime rate, often ranging from 2% to 5% above it for well-qualified borrowers.
Collateral for securing senior debt typically includes tangible assets like real estate, equipment, inventory, or receivables. The specific assets used depend on the business’s operations and the nature of the loan agreement.
Yes, senior debt can be refinanced. Businesses often refinance their senior debt to take advantage of lower interest rates, extend repayment terms, or improve cash flow conditions. Refinancing involves taking out a new loan to pay off an existing one, potentially with different terms that better suit the current financial situation of the company.
The primary tax implication of senior debt is that the interest payments made on the debt are tax-deductible. This deduction can reduce the taxable income of the company, thereby lowering its tax liability. This feature makes debt financing an attractive option for many businesses, as it effectively reduces the cost of borrowing.
In the event of bankruptcy, senior debt holders have the highest priority for repayment from the available assets of the debtor. They are typically paid off before any other creditors, such as subordinated debt holders or equity holders.
However, if the assets are insufficient to cover the entire amount owed, senior debt holders may not receive full repayment of their claims.
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