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Mezzanine finance can be a valuable tool for businesses seeking capital to fund rapid growth. This form of funding combines elements of debt and equity finance. It can offer flexibility and potential benefits for lenders and borrowers. However, before seeking mezzanine finance, you should understand its legal implications to ensure compliance and protect your business’s interests. This article will explain mezzanine finance and explore several critical legal considerations associated with this type of funding.
What is Mezzanine Finance?
Mezzanine finance is an unsecured business loan that established companies seek. These businesses typically use mezzanine finance to fund expansion, acquisitions, or other significant growth initiatives. It can generate substantial returns for investors. Such investors are usually existing long-term investors in a startup.
Mezzanine finance is a hybrid form of financing that blends debt financing and equity financing. The two types of mezzanine funding include:
- mezzanine debt; and
- debt-to-equity mezzanine financing.
The following table breaks down these two forms of financing.
| Type of Financing | Explanation |
| Mezzanine debt finance | Mezzanine debt is a form of subordinated debt that ranks below senior debt but above equity in repayment priority. Due to its higher risk, it typically comes with a higher interest rate. |
| Debt-to-equity mezzanine finance | Debt-to-equity mezzanine finance combines subordinated debt with an equity component, such as equity warrants or options. These equity instruments give lenders the right to convert their debt into equity under certain conditions. For example, if your business cannot repay the loan, the lender may obtain a share of ownership. |
What Type of Businesses Seek Mezzanine Finance?
Businesses with high non-repayment risks might seek mezzanine finance if traditional lenders deem their level of risk too high. Mezzanine finance provides these businesses with an alternative source of capital despite their higher risk profile. Additionally, companies seeking a substantial investment that a single lender cannot fully offer may use mezzanine finance to top-up the investment amount, helping them reach their capital goals.
Traditional banks are unwilling to provide the entire amount due to the high risk associated with the business’s limited operating history and the uncertain market reception of the new product.
The mezzanine loan includes an equity component, which allows the lender to convert the debt into shares under certain conditions.
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Key Legal Considerations
1. Investment Agreement
When receiving any form of finance, it is crucial that you read and understand the terms of the investment agreement. A lawyer can review these on your behalf, ensuring they are legally sound and sufficiently protect your business’s interests.
Mezzanine financing agreements often include restrictions that impose certain restrictions on the borrower. These restrictions are known as covenants. They may limit additional borrowing or refinancing to protect the investor’s interests. Negotiating reasonable covenants that protect the lender and do not restrict your business’s operations is essential.
2. Equity-Related Considerations
With debt-to-equity mezzanine financing, lenders will receive equity warrants or conversion rights as part of the financing terms. These rights enable investors to convert debt into equity under certain conditions. Moreover, you should ensure the terms of these equity instruments are clearly defined, including aspects such as the conversion price and any conditions.
Mezzanine debt is less diluting than pure equity financing as it blends debt and equity components. However, with any form of equity financing, you should bear in mind the risks of over-dilution and the impact of equity dilution on existing shareholders.
3. Due Diligence
You should conduct thorough due diligence on potential mezzanine lenders and prepare for them to do the same. Conducting proper due diligence will help select the right financing partner and avoid future conflicts. Your due diligence should include:
- reviewing their track record;
- understanding their investment approach, even if they are existing investors in your company; and
- assessing the impact of mezzanine financing on your business strategy.
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Key Takeaways
Mezzanine finance blends debt and equity products and suits high-risk businesses and those requiring substantial investment. It involves subordinated debt and equity conversion options. Additionally, mezzanine finance can provide the capital your business requires to fund significant growth.
However, this type of financing comes with complex legal considerations. By understanding mezzanine finance and its legal implications, you can leverage it to accelerate your business’s growth effectively. The necessary legal considerations associated with mezzanine finance include the following:
- drafting and negotiating an explicit investment agreement;
- understanding equity implications, including dilution and the need to establish clear conditions around how investors can exercise their rights; and
- conducting due diligence on your investors and preparing for them to do the same to your business.
If you require legal advice about mezzanine finance, our experienced startup lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0808 196 8584 or visit our membership page.
Frequently Asked Questions
Mezzanine finance is an unsecured business loan that blends debt and equity products.
Businesses with high non-repayment risks might seek mezzanine finance if traditional lenders deem their level of risk too high. Additionally, companies seeking a substantial investment that a single lender cannot fully offer may use mezzanine finance to top-up the investment amount, helping them reach their capital goal.
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