Mezzanine Loans: How Preferred Stock Works With Them

Mezzanine loans can be secured in several ways, including preferred stock of the company requesting the financing. Giving up preferred stock makes the lender a pseudo-partner in the financed project. It allows the lender to protect its interests in case the borrower defaults on the loan. The lender can use the preferred stock to take control of the project or property. Once the lender takes control due to default, they have the ability to sell it to another buyer or collect the income directly.

Preferred stock typically pays dividends to its shareholders. This is in place of voting rights that common stock shareholders receive. The dividend can be viewed in the same light as interest paid on bonds. Dividends give the lender equity participation in the borrower’s company.

How Preferred Stock Works

The way that preferred stock works is that it acts as security pledged by the borrower for the loan. The borrower and lender enter into a partnership or joint venture agreement that defines the role of each party. The agreement establishes the equity ownership of the lender and any other terms of the transaction. When dividends are paid by the corporation, the lender receives their pro-rata share in accordance with the amount of preferred shares they were issued.

Preferred Stock Example

The lender will receive a percentage of preferred shares in proportion to the amount of the loan. For example, a borrower seeking mezzanine financing of $5 million on a shopping mall project to be built on previously owned land, 5,000 shares of $1,000 par value preferred shares would be given to the lender as security for the loan.

Repayment of the Mezzanine Loan

Although the lender receives preferred stock as security for the loan, the borrower is required to pay the loan back as promised in the loan agreement. As the loan is retired, a portion of the preferred stock goes from the lender to the borrower in the same proportion, as specified in loan agreement. When the loan has been retired completely, the lender will have received payment with a portion of equity from the company and the company takes possession of the preferred stock ceded as security.

Preferred stock gives the lender some assurances that the loan will be paid back. In the event that the borrower defaults on the loan, the lender will step in and take ownership of the property or development that was financed with the mezzanine loan. The possession of the property gives the lender the option to continue to rent or lease the property for an income stream or sell it outright in order to recoup its loan.