When it comes to funding, there is a vast array of options available to suit individuals and businesses of all shapes and sizes. Some funding options are fairly straightforward, while others are more complex and difficult to understand fully.
One of the most complex funding options available is mezzanine finance which blurs the lines between debt and equity. It is a popular option because it offers some very high returns but is also one of the highest risk forms of debt available.
If you are considering mezzanine finance, it is vital that you properly understand the ins and outs of it, and what it can mean to you. This guide explains what mezzanine finance is, how it works and some expert tips to help you decide what is right for you.
What is mezzanine finance?
Mezzanine finance is a form of funding that is a hybrid between debt and equity finance. It is a complex option of financing that is popular for businesses as it can be used in a variety of situations. Equity, debt and mezzanine finance are three very broad categories of funding for businesses, and the first two are very common:
- Debt finance refers to most types of borrowing such as invoice finance, business loans and commercial mortgages. In simple terms, it means that the business is taking on some form of debt from a lender.
- Equity finance refers to selling shares in your business to an investor, which will result in any new stakeholders benefiting from your business growth or losing out on business failures. Equity finance is riskier to lenders as the value can fluctuate depending on the performance of the business.
Mezzanine finance sits somewhere between these two options, and the way that mezzanine agreements work can vary significantly between lenders. The overall idea behind it is that it is a combination of both the risks and rewards of equity investments, with the security and predictable nature of a loan.
A popular arrangement for mezzanine finance is a loan that will convert into shares in equity after a certain period of time or if the borrower can’t pay back the funds. Other arrangements use shares in a business as a form of collateral and security for a loan, which means if the business is successful and growing well then, they will be able to borrow more than they could from regular debt options.
Mezzanine finance can allow a business to leverage its future profits for the maximum possible return. In most cases, it uses a combination of a loan, mezzanine agreement and your own cash.
What is mezzanine finance used for?
As well as being used by businesses, this type of funding is also popular among property developers as it can be used for financing part of a building development project’s costs. Funds can be released over time as work on a property project progresses, and more money is required. In most cases, mezzanine finance is secured as a second charge behind the project’s main lender for a development.
The majority of mezzanine finance agreements will have an agreement that the lender will receive their initial investment back plus interest, as well as a pre-agreed percentage of the development’s profit. It gives the lender the right to convert to an equity interest in the case of a default on the loan.
In most cases, mezzanine finance tends to be completed with little due diligence from the lender, and no collateral from the borrower. Instead, it will be treated as equity on the company’s balance sheet.
Why use mezzanine finance?
There are various benefits to mezzanine finance, particularly for businesses. The key benefits include:
- Business owners are unlikely to lose complete control of their company, and as long as the company grows, it is unlikely that the mezzanine lender will have any involvement.
- A lot of flexibility for business funding options and gives borrowers the opportunity to specify special repayment conditions.
- Lenders of mezzanine finance are more likely to be long term investors as opposed to lenders looking to make some fast money.
- Mezzanine finance lenders can offer valuable assistance to the business.
- It can provide business owners with the capital they require to expand and grow.
Arranging mezzanine finance can be a long process compared to other lending options, and in some cases can take months to arrange and complete. If you are considering mezzanine finance, it should be a long term finance solution.
