4 Dangers of Mezzanine Loans

Mezzanine loans are a specific type of financing gained by offering subordinated debt to a lender through a type of stock or equity arrangement. Mezzanine financing may come from banks, but it more often comes from mutual funds, private investors or insurance companies or pension funds. Because lenders are signing up to be subordinated to other types of debt, meaning they will get paid last if there is a bankruptcy, they look to secure their position in other ways. While mezzanine loans can provide fast cash for start ups or expansion ventures, beware of these dangers.

Danger #1:  High Rates

The number one affect of utilizing a mezzanine loan is the high cost you will pay the lender. Some lenders structure this as monthly payment with a high interest rate. Others will structure this based on the yield your company generates through operations and sales. If a mezzanine lender determines your business plan has a good chance of immediate and high yields, the lender will likely look to profit by taking a portion of your profits or operating under a revenue share agreement. 

Danger #2: Relinquish Control

Depending on the way you structure your financing, the lender will have a degree of control over your decisions. Business owners and entrepreneurs are typically highly independent and strong-willed, making ceding this control to an investor very hard to stomach. However, it is not uncommon for a mezzanine loan to include a vote on the board. The lenders are looking to protect their stake in the company, especially because they will be last in line to be repaid if the venture does not succeed.

Danger #3: Loan Restrictions

The lender will have no stake in the assets of your company. Because of this, the lender will likely place restrictions on your financial decisions in order to maintain some security in the loan. They may place limits or restrictions on how much you can borrow from other sources. It is also not uncommon for the lenders to prevent refinancing or loan modification of other loans you are working with. You may be precluded from increasing the stock or dividends in your company. The lender makes these restrictions to ensure your financial status does not drastically change before you have repaid the loan to them. 

Danger #4: Hassle and Time

Perhaps the biggest drawback of mezzanine loans is the hassle and time it takes to come to an agreement. Because the lender is assuming a high degree of risk, they will carefully argue for every single point on their agenda with the eventual contract. It is not uncommon for a loan agreement to take 3 months or more to finally come to fruition with mezzanine financing. In the meantime, your business may be operating with a negative cash flow or stalled entirely from seeking the desired expansion. Only enter mezzanine financing discussions if you have a solid business history and good financial health. This will prevent the process from dragging on. Then, once this financing is arranged, it can help your balance sheet further in the future.