Businesses in need of capital have a variety of financing tools available to them. Traditionally, this includes borrowing through loans or attracting investment through the sale of shares. However, between these two approaches lies an alternative—mezzanine finance. This hybrid financing method blends aspects of loans and equity investment, offering unique benefits and specific risks. This guide explores how mezzanine finance works, how it compares to other financial options, and the situations in which it may be the right move for your company.
Defining Mezzanine Finance
Mezzanine finance is a layered form of funding that incorporates both loan-like and investment-like characteristics. It generally comes into play when a business has exhausted its borrowing capacity through conventional loans or needs more capital than a bank is willing to provide.
The word “mezzanine” comes from the idea of a middle floor—fitting, since this funding sits between traditional debt and full equity on a company’s capital structure. While typically structured as a loan, mezzanine financing often includes an option for the lender to convert their loan into shares if the borrower defaults.
Because it’s not backed by physical assets, this form of funding is considered unsecured. However, in exchange for this higher risk, lenders usually demand higher returns—either through interest or eventual equity participation.
Comparing Mezzanine and Traditional Loans
Debt financing typically involves taking out a fixed sum from a lender and repaying it in instalments with interest. These are often structured, predictable, and backed by assets or guarantees. Examples include business loans, overdrafts, and equipment financing.
Mezzanine finance, however, ranks lower in the priority chain of creditors. In the event of insolvency, banks and other secured creditors get repaid first. Only then do mezzanine lenders recover their investment, which is why they often require higher returns to justify the elevated risk.
In some cases, mezzanine lenders negotiate safety clauses. If a borrower is unable to meet repayments, they may claim equity in the business. This equity option gives them a way to recover value, albeit over a longer timeframe.
How Mezzanine Differs From Equity Financing
Equity finance involves giving up a portion of business ownership in exchange for capital. Investors who participate in equity deals—such as angel investors or venture capitalists—buy shares in the business, betting on its long-term success. They typically expect dividends or a capital gain if the company is sold or goes public.
Equity investors are generally more involved in the strategic direction of the business and may hold voting rights. Their return is tied directly to the performance of the business.
In contrast, mezzanine lenders are not shareholders from the outset. They function more like creditors but with the option to convert to ownership if the borrower defaults. If the business were to collapse, mezzanine lenders would still be repaid before equity holders, making this type of finance slightly less risky for them compared to outright equity investment.
From a business owner’s perspective, mezzanine finance offers a middle path: you gain access to larger sums without immediately diluting control over the company, as you would with equity finance.
A Real-World Illustration of Mezzanine Funding
Let’s say a company requires £1 million to launch a new expansion project. The bank, after reviewing the project risk, is only willing to lend £600,000. The shareholders step in with £200,000, but that still leaves a £200,000 funding gap.
Instead of giving up more equity, the business chooses to secure mezzanine financing to cover the remainder. This way, the company can move forward with the project. If the company meets its income projections, the mezzanine loan is repaid like a traditional loan. If the business struggles, the lender may convert the outstanding balance into equity.
This hybrid arrangement provides the flexibility the company needs without immediately compromising ownership or relying solely on a bank loan.
Benefits of Mezzanine Financing
Access to Larger Capital Pools
One of the primary attractions of mezzanine funding is the ability to raise larger sums than would be possible with traditional loans alone. This makes it a useful tool for companies preparing for expansion, acquisitions, or significant capital projects.
Preserves Ownership Initially
Mezzanine loans typically don’t require the borrower to give up ownership unless they default. This enables business owners to retain full control, unlike equity financing, where investors often demand a say in operations.
Helps Diversify Funding Sources
Using mezzanine capital allows businesses to reduce dependency on a single lender or investor. Spreading the funding load can make your financial structure more resilient to shocks or changes in circumstances.
Appealing Balance Sheet Representation
Since mezzanine finance often appears under equity on a balance sheet, it can improve the company’s financial ratios. This, in turn, might make it easier to secure additional funding from other sources in the future.
Less Involvement from Lenders
Unlike equity investors, mezzanine lenders typically do not seek to influence management decisions. Their concern is with repayment terms and financial performance, not operational control.
Drawbacks of Mezzanine Finance
Elevated Interest Rates
Given the higher risk, mezzanine loans often carry substantial interest charges, commonly ranging between 10% and 30%. If a borrower struggles to repay, the cost could be even higher once converted into equity. For businesses with tight margins, this may not be sustainable.
Slower and More Complex Process
Because of the legal and financial structuring involved, mezzanine finance can take longer to secure. Due diligence requirements are usually more extensive than for simple loans, and negotiations over terms can prolong the process.
Potential for Ownership Dilution
While the borrower may not surrender equity initially, defaulting on repayment terms can trigger ownership transfers. This conversion can reduce the founding team’s stake and influence over the business.
Exposure to Variable Interest
Some mezzanine arrangements include a mix of fixed and floating interest rates. If market rates rise unexpectedly, your repayments could increase, putting further strain on your cash flow.
Increased Credit Risk
Since this form of funding is unsecured, failing to meet obligations can significantly damage a business’s credit profile. Defaulting on mezzanine debt may reduce access to future funding and limit financial flexibility.
When Mezzanine Finance Makes Sense
This financing model suits businesses that are beyond the startup phase and seeking aggressive growth. It works well for those with consistent revenue streams and ambitious plans that cannot be fulfilled through traditional borrowing.
Mezzanine finance is particularly valuable during mergers, buyouts, or high-cost expansion efforts. It also appeals to companies that want to raise capital while maintaining as much control over their enterprise as possible.
However, it’s essential to assess your company’s capacity to service the debt, withstand potential equity dilution, and endure shifts in interest rates. A clear growth plan, reliable cash flow projections, and strong financial management are prerequisites for making the most of mezzanine capital.
Conclusion
Mezzanine finance serves as a flexible, albeit complex, solution for businesses in need of substantial funding. By straddling the space between loans and equity, it offers companies access to larger capital reserves without the immediate surrender of control. While it brings opportunities, it also introduces risks that must be carefully managed.
For businesses considering this route, it’s crucial to evaluate both the financial and strategic implications. With careful planning and professional guidance, mezzanine finance can provide a valuable springboard for future growth.
Frequently Asked Questions about Mezzanine Finance
How does mezzanine finance differ from traditional debt?
Unlike secured debt, mezzanine finance is unsecured and carries higher risk for lenders, resulting in higher interest rates and potential ownership conversion if the borrower defaults.
How is mezzanine finance different from equity investment?
Equity financing involves giving away company shares upfront, while mezzanine lenders only gain equity if the business fails to meet repayment obligations.
When is mezzanine finance a good option?
It suits growing businesses needing large capital for expansions, acquisitions, or bridging gaps when traditional loans and shareholder contributions fall short.
What are the benefits of using mezzanine finance?
It allows access to higher funding, preserves business ownership initially, improves balance sheets, and usually doesn’t require lender involvement in operations.
What are the main risks associated with mezzanine finance?
Risks include high interest rates, longer approval times, equity dilution if repayments fail, exposure to interest rate changes, and increased credit risk.
Who typically uses mezzanine finance?
Established businesses with consistent revenues and growth plans, especially during mergers or large capital projects, are common users of mezzanine funding.