In the Byzantine world of business finance, there is one concept any small business entrepreneur should become well-acquainted with: mezzanine business loans. The idea of using this type of financing to underwrite your small business gives a new level of possibilities, something small business owners often seek. This article will define some important terms and concepts in such a way that you can grasp what mezzanine loans are and how they work.
Why Is the Mezzanine Where It Is At?
If you have been to the opera, you know that the mezzanine is that layer of seats between the balcony and the lower level. Mezzanine financing is pretty much the same. Often, when an entrepreneur is attempting to refinance a business or to obtain money for an expansion, venture capitalists or traditional investors may not want to underwrite the entire project. At the same time, the business owner does have some valuable equity of some type as well as some income. The mezzanine lender steps up to underwrite the part of the project that exceeds what the traditional lenders are willing to cover.
What Is Senior Debt?
To fully understand what is happening, first, you have to grasp the term senior debt. If several different lenders underwrite an entrepreneur’s business project, they do not all have the same kind of loan and repayment agreement. Traditional lenders, often like banks, have senior debt, which means that they get paid first when the time comes to make repayments. Thus, if an agreed-upon payment date rolls around, the senior lender is first in line to get paid. Senior debt is usually more conservative and is usually considered less risky. The mezzanine lender might not get paid if the borrower does not have the funds to make both payments.
What Is Equity?
Essentially, when talking about a business, equity is the amount a business is worth after meeting all its liabilities. When deciding how much to loan a business, lenders consider how much the business owes—its debts (liabilities) and how much it is worth—its assets (equity). This formula is called the debt-to-equity ratio and it is used in a variety of ways, such as determining stock value and a company’s overall worth. In the case of a business loan, the equity of the company, its income and its debts are used to determine how much a lender might risk.
What Make a Mezzanine Loan Attractive for Lender and Borrower?
While mezzanine loans are higher in risk and their interest rates are higher, there are some advantages to this type of financing for borrowers and lenders:
- Typically, the higher interest rates are paid off quickly, rolled into the total loan amount or refinanced.
- Mezzanine loans are often easier to negotiate on the secondary market.
- Lenders may choose to take part of their payment in equity, making them part owners of expanding companies.
- The return on a mezzanine loan is often closer to the higher return on stock equity than loan debt.
For a borrower or a lender, sometimes it pays to stay on the mezzanine level.