The Risks of Mezzanine Financing
Mezzanine financing is a unique type of subordinate lending used by businesses to extend the limits of their loans. A business owner who needs more cash than a lender may provide can seek out mezzanine loans. These loans are provided by private equity groups, hedge funds, mutual funds and other private investors. This mezzanine capital is not a loan, but the business provides equity or profit-sharing opportunities to a lender. While mezzanine borrowing can increase the amount of capital a business can secure, it also presents unique risks.
More Expensive than Secured Loans
Any time you opt for unsecured financing over secured financing, you will see much more expense associated with the loan. Mezzanine loans are also subordinate loans. This means they will take a back seat to your senior loans in case of bankruptcy. Mezzanine lenders are assuming the vast majority of the risk associated with your loan as a result of these factors. Whenever a lender assumes more risk, you will have to pay more for the loan. With this type of financing, the expense is paid through the large amount of equity or profit you give to the lender instead of a high interest rate.
Share of Profit
Sharing your profit is one way to secure a good loan, but this means you will have to continue to hand over a portion of your own paycheck. When you structure your financing this way, the more you make, the more you owe. This is common with all companies that share profit, whether through mezzanine loans or through stock options for investors. However, it means that you will not know the exact expense of your loan at the time you agree to the contract. Your loan may be more expensive one month than it is another month, making it difficult to factor in the true total cost of the loan.
Share of Equity
Sharing equity presents many of the same risks as sharing profit. However, sharing equity is riskier in the long-run than profit sharing because it can affect your earnings should you offer public shares of your company. One of the greatest advantages to owning or starting a business is the potential to sell the business in the future. Business owners usually have the goal of cashing out down the line, securing a retirement. When you use mezzanine financing, a portion of any profit from a sale will go to the original financier.
Share of Responsibility
Sharing the responsibility of making decisions for your business can be both a risk and a reward for business owners. Some will appreciate having the support and advice of a new board member or a partner. Others will want more of a silent partner; they will seek financing without offering any ability to direct the company's decisions to the financier. In most cases, you will have to answer to your investors with mezzanine loans. If you like to make your own decisions without answering to anyone at all, this can be a huge risk to the way you do business.