Posted on: December 21st, 2023
When funding a deal with risk, mezzanine debt lenders expect to receive a return enhancement known as a warrant. Despite its ominous -sounding name, the warrant is merely a contract right to participate in the future valuation gains of the company. The warrant is expressed as a percentage of share ownership and simulates a minority ownership in the company.
Mezzanine debt warrants are used selectively in certain types of deals. These include direct lending deals where the lender is the sole provider of institutional capital, high-priced deals with above-market level leverage ratios and roll-ups where there is a high degree of execution risk. Warrant values increase proportionately to the valuation growth of the enterprise. If the mezzanine debt warrant is 5%, and the company valuation grows from $5 million to $10 million, the warrant value increases by $250k. This is a manageable level of warrant accretion. However, big growth runs can lead to huge warrant value accretion. When this happens, the company may have a $2 to $3 million warrant value on its hands that needs to be reckoned with upon a refinancing or exit.
This example underscores the growth company funding conundrum. Prior to scale-up, growth companies are risky due to their size and attendant level of execution risk. Once they successfully scale up, the lender’s position is materially de-risked leading to above-market loan pricing. This creates a capital pricing misalignment where the company is no longer a mezzanine debt risk but is still paying mezzanine debt pricing. The solution to addressing the pricing misalignment is to plan ahead and start a refinance process early. Most mezzanine debt refinancings take 60 to 70 days or so once launched in the market. The earlier you start this process, the sooner you will bring the cost of your capital in line with the risk level of your company.