To understand mezzanine funding, you need to understand what a company’s capital structure is. This is the collection of funds for the business that enables you to run the business operations, growth, assets and other running costs. It consists of a mixture of debt, such as loans, and equity, like the owner’s funds, retained earnings or money that shareholders have given for shares.

Within this collection, not all capital is equal; Senior debt (the highest priority debt) sits at the top, followed by junior debt and equity funding below it. But sometimes, a gap starts to form between the two. This is where mezzanine funding steps in. Mezzanine financing is a non-traditional form of funding that borrows against shares of the company, meaning that if the borrower defaults, the lender receives shares to cover the debt.

It is the last resort for businesses that desperately need a loan but cannot get approved by traditional lenders. This only happens when the company is unable to clear senior debt before acquiring a new loan. Whenever equity funding is needed, the equity funding gap can be filled with mezzanine debt to prevent shareholders from giving up too much equity and suffering too much equity dilution.

Create Room for Cash Flow: You can cover a portion of senior debt through mezzanine funding in order to relieve the pressure on working capital, creating more cash flow availability.

Keeps You in Control: Since mezzanine funding doesn’t take up ownership unless you default, founders remain in control of their businesses while also gaining capital. In certain cases, businesses can also use mezzanine funding to fund buy-backs of shares or refinancing of shareholder loans and dividend recaps.

Execute Long-Term Strategies Before Loan Maturity: Typically, mezzanine funding matures after four to seven years. This means that there is enough time to execute vital strategies that build growth in a business, building up momentum until you have to pay the loan.

Advantages

No Heavy Collateral Needed

This type of funding uses the business’s performance and future potential as an indicator of loan repayability, not assets to borrow against.

Tax Benefits on Interest

The interest on mezzanine debt is usually tax-deductible, making the overall cost slightly more affordable.

Fuel for Bigger Moves

Mezzanine capital fund major financial events, like buying another company, taking over a partner’s share, or scaling faster than a bank loan can allow.

Cheaper than Raising Equity

Accessing mezzanine funding is much more affordable than raising equity. Raising equity can be time-consuming and, in some cases, does require you to surrender a portion of your ownership.

Disadvantages

Higher Interest Rates

The lender expects higher returns because they take a higher risk. Borrowers can expect an interest rate of 17% and above. The business only has to service interest payments during the loan tenor, thereby creating cashflow headroom, and the business can reinvest the excess cashflows for growth.

Defaulting on Payments Leads to Loss of Ownership

If one payment lapses, the business owner(s) will be required to sacrifice a portion of their equity.

May Include Further Restrictions on Loans

Because you are adding mezzanine debt to your capital structure, acquiring additional financing may be inhibited.

Mezzanine debt blends debt features (interest) with equity-like returns (upside), offering flexible growth capital with contractual returns for investors. These loans are useful if you want to do the following:

• Recapitalisation of an existing business.
• Finance buyouts from shareholders.
• Growth capital for scaling.

Mezzanine funds leverage up to 3,5 to 4 times the Total Debt (senior and mezzanine debt) to EBITDA and/or up to 80% LTV (Loan to Value – senior and mezzanine debt).

Mezzanine debt loan funding is typically a five to six-year flexible bullet loan funding with capital repayable right at the end of the maturity of the loan.

Mezzanine debt funding from R70 million to R205 million can be accessed by medium-sized businesses generating a minimum of R25 million in Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA) per annum.

Businesses operating across all sectors, including real estate, can apply. Excluded sectors are primary mining, resources, commodities, primary farming, micro lending, gambling, ammunition, hard liquor, tobacco and government.

To qualify, you must have operations in either South Africa, Botswana, Namibia, Swaziland, or Lesotho. You will also need a 20% equity cushion sitting behind the mezzanine debt.

When applying, ensure you have the following information available:

• Bank statements – last three years.
• Tax returns – last three years.
• Details of the company structure and share allotment.
• Profit and loss statement, balance sheet, cash flow forecast.
• Details of existing debt.
• List of major customers and suppliers.
• List of any patents, copyrights, or innovative technology.
• Business plan – as comprehensive as possible.

Comprehensive due diligence will be conducted. You can expect a security package, financial covenants, active monitoring and governance through board observers that ensure downside protection.

Exits are mainly achieved through senior debt refinancing after EBITDA growth and de-gearing of the investee company.