How Community Development Finance Institutions could support your business

When it comes to business funding, there are three main types of products a business can access.

The first is debt finance, which is when you borrow money and agree to pay it back with interest.

Next, there's equity finance, where you give away a piece of your business in return for a capital injection.

The third category is known as mezzanine finance which features characteristics of both debt and equity finance.

In this guide we’ll explain what mezzanine finance is, the differences between it and other types of financial products like debt and equity, and the pros and cons of using it.

As with any financial product, it’s a good idea to seek independent financial advice before deciding which product is right for your business and its circumstances.

What is Mezzanine finance?

Mezzanine finance is a type of unsecured business loan that is a mix of two different types of financing: equity and debt products.

The term mezzanine comes from the word ‘mezza’ which is Latin for middle.

Whilst it’s more complex than other forms of finance it's a way for lenders to help companies grow and make money, while also giving them some protection in case things don't go as planned.

If the company can't pay back the loan, the lender might be able to get a share of ownership of the company instead.

This usually happens after other lenders and investors have been paid first.

Mezzanine finance could be an option for a business when the perceived risk of non-payment is large enough that the business cannot secure a traditional business loan or if the total amount required is so large that a single lender is unwilling to provide the full amount.

Mezzanine finance vs Debt finance

Debt finance involves the borrowing of a lump sum, which is then repaid in full over time with an added agreed-upon amount of interest.

Types of debt products include bank loans, working capital products like overdrafts and invoice finance, and commercial mortgages.

If a business using debt, and mezzanine finance were to fail there is a specific order in which creditors will receive their money.

First would be the senior debt lender, often a bank who lent the business money in the form of a debt product.

Once those creditors have been repaid, the lender of the mezzanine financing would be next, meaning mezzanine finance is seen as riskier to the lender than normal debt finance, hence the typically higher interest rate for these products.

However, in some cases, mezzanine agreements have safety nets.

If the business can't pay back the loan, the lender can exchange the remaining loan for a share in the company.

This means the mezzanine finance lender can lend amounts typically larger than would otherwise be obtainable through regular debt finance like a secured loan.

Learn more about Debt finance.

Mezzanine finance versus Equity finance

Equity finance involves the selling of shares in a business to raise funds.

When investors provide capital to a business, they become shareholders.

Types of equity investment includes Angel investment, Venture capital, Equity crowdfunding and Initial Public Offering (IPO).

The value of their stake in the business goes up or down depending on the fortunes of the business which makes this particular type of finance risky for the investor.

Unlike debt lenders who will only be involved with a business until the debt is repaid, investors are often attached to a business long-term and will look to see it grow to maximise their profits.

If a business using equity, and mezzanine finance were to fail there is a specific order in which creditors will receive their money.

In this example, the first creditor to be repaid would be the lender of the mezzanine financing before the equity investor.

Furthermore, because the mezzanine finance lender has the option to convert the loan into equity, mezzanine finance is seen as lower risk than equity finance.

This is why some businesses use mezzanine finance; it provides a larger amount of funding but allows a business to limit the amount of equity investment required from other sources, meaning the business owner retains more control over their business.

Learn more about Equity finance.

Mezzanine Finance example

A good example of how mezzanine finance can support a business would be if a company needs £1,000,000 to fund a project.

Due to the risk profile of the project, the business’s bank has only agreed to offer a £600,000 loan whilst the business’s shareholders have agreed to provide an additional £200,000 towards funding the project.

However, this leaves a shortfall of £200,000 to fully fund the project.

Upon completion of the project, the company forecasts additional income generated by the completed project which can be used to service the funding agreements.

The company elects to apply for a mezzanine finance product which will provide the additional £200,000 to make up the shortfall.

If the company defaults on the loan the lender has the right to convert the mezzanine loan into equity ownership of the company.

Though this example is a simplified scenario it illustrates the general idea of how mezzanine financing can be used in the UK.

Advantages of using mezzanine finance

Mezzanine finance offers business owners a number of advantages over more traditional forms of finance.

Diversification of finance

By accessing mezzanine finance, a business can reduce its dependence on any one investor or lender, which could lead to greater business resilience.

Can access much higher amounts

It’s possible to obtain larger amounts of funding through mezzanine funding than more traditional routes to finance.

For this reason, mezzanine finance can be a popular option for scale-up businesses, especially those looking to conduct a merger, a business acquisition, or property transaction.

Cheaper than equity financing

Due to the part-debt, part-equity nature of mezzanine finance, a business owner doesn’t have to give up any stake in ownership of the business unless they are unable to repay their loan.

Furthermore, some lenders may not exert much influence over the day to day running of the business beyond the terms and conditions of the loan.

Structure of capital

Mezzanine finance is often shown as equity on a company's balance sheet.

This helps keep debt levels low, giving the business a healthier financial appearance.

Disadvantages of using mezzanine finance

As with any financial product, there are a number of disadvantages that a business owner should consider before applying.

Higher cost than debt financing

Due to the higher perceived risk to the lender, interest rates tend to be more expensive for mezzanine finance than for more traditional debt products.

A typical range for this type of financing is between 10% and 30%.

The higher rates usually happen when a lender gets a piece of the company instead of cash.

Although this offers some safety, turning it into cash can take time if things go wrong.

So, lenders protect themselves by charging a higher interest rate.

Longer lead in times

Due to the complexity and the higher risk, it can often take quite a long time to successfully apply for mezzanine funding.

The process can also include due diligence on the company.

Can reduce equity

Due to the nature of mezzanine finance, in order to obtain the product a business needs to offer securities to the lender that can dilute the equity of the business.

Risk of interest rate change

Often the repayment terms of the product are structured to include both fixed and variable interest which means that, should interest rates go up, the monthly repayments a business needs to meet will also increase.

This could make it tougher for a business to manage its finances.

Risk of default

Since mezzanine finance is unsecured debt, it increases the risk of a business defaulting and negatively impacts a business’s creditworthiness.