January 12th, 2021

Mezzanine Debt Agreements – A Primer for Borrowers
At many points in the life of a start-up venture, owners will have to choose between different financing options to sustain and grow their business. Subordinated or “mezzanine” debt is a popular financing vehicle for Canadian high growth companies in their earliest stages. There are many complexities to mezzanine debt that distinguish it from the typical bank loan and which prospective borrowers should consider when making their financing decisions.

What is Mezzanine Debt?
Mezzanine debt is a loan with components that give it some of the characteristics of holding equity. With both debt- and equity-like features, mezzanine debt occupies a middle ground between senior debt (i.e. secured bank loans) and common shares in terms of risks and rewards. This is especially evident when a borrower defaults on their agreement – lenders of mezzanine debt have lower priority than senior lenders in their claims against a company’s assets when that company becomes insolvent. As such, mezzanine debt is usually (but not always) unsecured, meaning that lenders are dependent on the company’s cash flows as a going concern to protect their principal.

What Gives Mezzanine Debt It’s “Equity” Feature?
The equity component is attached to the loan agreement in two ways:

1. Conversion option – gives the borrower the option to convert the outstanding balance into common shares;
2. Share purchase warrants – rights to purchase the company’s shares at a set price.

The main legal differences between the two are that in an agreement with a conversion option, using the option will cause the debt to disappear, along with all the rights and obligations of the loan. Exercising warrants will not have this effect. Conversion options also cannot be separated from the agreement. Warrants can be separated and sold off to another party. Outside of these differences, the two components are economically equivalent.[1]
​
How Much Does Mezzanine Debt Cost?
Mezzanine debt usually charges a higher interest rate than senior debt (usually 12%-15% per year).[2] Lenders may also charge a variety of fees on top of that interest, including setup fees, monitoring fees, late payment fees, prepayment fees, and so on.

Lenders are legally required to disclose the annualized nominal interest rate on their loans.[3] For example, if lender charges 1% interest per month, the lender must indicate this as 12% interest per year. However, this number does not include three things that affect the cost of borrowing:

1. The effect of compounding,
2. The effect of additional fees, and
3. The effect of prepayments.

Including these items would increase the total cost of borrowing as a percentage of the principal balance (for legal purposes known as the effective interest rate). Especially with mezzanine debt, the difference between the reported interest rate and total cost of borrowing can be significant.

Mezzanine debt often includes penalty interest to encourage borrowers to make payments on time. Penalty interest is also not included in the nominal interest rate. If the loan is secured by real property, then the lender cannot increase the interest rate even in default.[4] In this case, the borrower may see that fees are charged instead of additional interest when in default, though it is unclear whether this would qualify as interest.[5]

It is illegal under criminal law for lenders to charge interest greater than 60% per year on the amount advanced.[6] Criminal law considers interest to include all applicable fees as mentioned above. Prepayments also increase the interest rate as it lowers the amount advanced on which the interest charged is calculated, increasing the percentage as a result. The combined effects of additional fees, prepayments, and the already high interest rates can make the effective interest rate greater than 60%. Because of this, lenders will often include “black-out periods” in their agreements where prepayments cannot be made for a few weeks, especially after the loan is given or after fees are charged.[7]

What Terms Do Mezzanine Debt Agreements Have?
Mezzanine debt agreements often include provisions that the loan will be subordinate to any future senior debt agreement, so undertaking mezzanine debt would not preclude a borrower from seeking secured bank loan down the road.

If a borrower already has a mezzanine loan and later secures a senior loan from a bank, the bank may require the borrower and mezzanine lender to sign an inter-lender agreement. This protects the bank by ensuring that it has first charge all the borrower’s assets (except for assets secured by the mezzanine lender, if any). It may also set terms as to:[8]

1. The maximum amounts that may be advanced by each lender,
2. Allowable repayment amounts to the mezzanine lender,
3. An obligation of the mezzanine lender to notify the bank of any default by the borrower on its agreement, and
4. How each lender may proceed against the borrower in the case of default.

Lenders will sometimes take security in a mezzanine debt agreement. Unlike senior loans, collateral often includes assets like intellectual property, share pledges, and life insurance proceeds. Intellectual property can include trade secrets, patents, copyrighted works, and trademarks.
​
Due to the risk mezzanine lenders face in providing unsecured loans (or taking intellectual property or other assets with uncertain value as collateral), lenders tend to avoid forcing a borrower into bankruptcy in the case of default. Instead, they may convert their debt into common shares and provide additional financing. This gives the lender additional control over the business while sustaining it as a going concern.[9]

    _______________
[1] Bryce C Tingle, Start-up and Growth Companies in Canada: A Guide to Legal and Business Practice, 3rd ed (Canada: LexisNexis Canada) at 386.
[2] Ibid at 383.
[3] Interest Act, RSC 1985, c I-15, s 4.
​[4] Ibid at s 8.
​[5] Supra note 1 at 390.
​[6] Criminal Code, RSC 1985, c C-46, s 347.
​[7] Supra note 1 at 392.
​[8] Ibid at 407.
​[9] Ibid at 426.