Mezzanine finance gets its name because it sits in the middle between debt and equity finance. It’s a complex form of business funding, but can be useful in a few different situations, representing a third option to be used alongside a standard loan, equity fundraising, or both.

Let’s have a closer look at mezzanine finance.

Debt and equity vs. mezzanine

Debt, equity and mezzanine finance are the three broad categories of business funding, and you’re probably familiar with the first two.

Debt finance is the technical term used to describe most borrowing, whether it’s a business loan, invoice finance or a commercial mortgage. The details vary, but the underlying concept is that the business is taking on a debt — the lender gives you cash in return for regular repayment that adds up to the principal amount borrowed plus interest. Therefore, with debt finance the lender usually has a clear idea of how much they’ll get back, often with a set timeframe too.

Equity fundraising, meanwhile, sells shares in your business to investors, and your new stakeholders will benefit from any growth in your company (and suffer any losses too!). The portion of the business they own can go up and down in value depending on how your firm does in the future, which means it’s a riskier proposition and usually part of a longer-term strategy for venture capitalists and private investors. In other words, unlike debt finance lenders, equity investors are usually in it for the long-haul.

In the middle

Mezzanine is the third way. The mechanics vary between lenders, but the overall idea is that it’s a combination of some of the risk and reward of equity investment, combined with the more predictable middle-term income of a loan.

One common arrangement is a loan that ‘converts’ to an equity share after a set timeframe elapses, or at the lender’s discretion; which means if things go well, the business can pay back the money, but if it can’t, the lender can recover costs via shares in the business that increase in value.

In other scenarios, mezzanine funding uses shares in the business as a form of collateral for a loan, so the future growth of the business enables it to borrow more than it would get from a ‘senior debt’ with a regular lender.

Examples

Mezzanine finance is best thought of as a kind of ‘top up’ funding for big projects. Say you want to raise £10 million, and you’ve agreed a loan for £7 million with a standard lender. Through a mezzanine agreement you might secure another £1.5 million, meaning you need to put in £1.5 million yourself instead of £3 million. Or alternatively, you could put in the same amount yourself but have a project fund of £11.5 million instead of £10 million.

In this way, mezzanine finance allows you to leverage future profits for the maximum return with the cash contribution you have available.

>See also:

How mezzanine finance can help ambitious SMEs to grow

Mezzanine finance is often used for management buy-outs. In these situations, it’s an entire business being financed rather than a specific project or expansion. Using mezzanine for an MBO depends heavily on the specific circumstances of the businesses and individuals involved so it’s hard to make generalisations, but overall the value of the business being bought is the main factor in the amount raised. It’s also a common method of funding property development, where projects won’t realise any revenue until the work is complete.

Pros and cons of mezzanine funding

Pros

• If the company continues to grow, it’s unlikely that the owners will lose outright control
• It’s flexible, offering various repayment schedules and structures to suit the business
• Mezzanine can make the difference in unlocking the funding needed for a project or acquisition

Cons

• If the company’s fortunes don’t go as planned, the business owners may lose some control over its future
• The requirements of mezzanine lenders can be restrictive, for example in terms of security or personal guarantees required
• It’s often more expensive than similar amounts of debt finance
• Mezzanine finance can take a long time to arrange (3–6 months)

Final thoughts

Mezzanine finance is a complex area of business funding, but it can be a useful way for companies to raise more money than would otherwise be possible based on the strength of the current business alone. Or, it offers an alternative to selling large amounts of equity outright, which may be preferable for business owners wishing to keep as much control as possible.

Overall, it’s worth exploring if you’re considering an acquisition, management buy-out, or a large new project.

Conrad Ford is chief executive of Funding Options.