Is Mezzanine Financing Worth the Risk? What Every Business Should Know

To the uninitiated, mezzanine financing appears risky, and certainly riskier than a simple bank loan. Given its higher interest rate and larger loan amount, most founders tend to avoid it due to fear of overleveraging. If a company is not used to operating with debt, it does take some adjusting to as mezzanine lenders are more focused on current and future financial performance than most banks are.

Why Mezzanine Debt Is Safer Than It Looks

Ostensibly, mezzanine debt adds financial risk but pragmatically, it is less risky than a bank loan in several ways.  Banks are highly collateral focused and often their loans are fully secured. If they decide to exit your loan, they are eyeing the assets that secure their loan and look to sell them or liquidate them to get out of the loan. They do not care much about what impact this has on your profit or cash flow, they just want out and will do what they must do, at the risk of seriously destabilizing the business. Most banks also require personal guarantees which gives them another exit path to use if they want out. Additionally, banks are increasingly miserly in their loan amounts. High levels of regulation have reduced their ability to lend, making them increasingly non-relevant to growth and acquisition funding deals.

Mezzanine financing providers, on the other hand, usually lend to companies far beyond their collateral amounts, often 3+ times a company’s balance sheet collateral. They look to the profit engine and the gross margin underpinning of the business to validate its degree of specialization and defensibility. Locking into this enables them to gain long-term comfort and to lend based on future cash flow growth. This means that the mezzanine financing provider issues large loans based on cash flow growth, supported by very little collateral.  Their perpetually undercollateralized position gives them very little room to act impetuously and force an exit like a bank can. If their loan is $15 million and their collateral is only $5 million, they will sustain a big loss if they foreclose. They could potentially foreclose on the stock and try to force a sale of the company but that is messy and usually ends up in bankruptcy.

This natural state of lending more with less collateral forces the mezzanine financing provider to be patient and supportive to their borrowers, over long periods of time. Conceptually, mezzanine debt is more equity than debt due to this very fact. Even though the loan looks formidable and threatening, it poses less disruption and forced-exit risk to the business than a bank loan. Mezzanine debt is 100% worth the risk because, in essence, it is cheap equity that can drive massive growth of your business.