Mezzannine Financing for Business - What it is, how it works & more

Mezzanine finance is often used to compliment other forms of funding on projects and is ideal for a business with the potential for years of growth and sustainable profits.

Why would you use mezzanine financing?

Just as a mezzanine floor slots in between two storeys in a building, so mezzanine financing sits between two different, but common, kinds of UK funding: debt and equity.

Mezzanine capital can be complicated and the models offered by mezzanine finance providers can vary. In the simplest terms, it is a loan made against a potential stake in a company’s equity. The lender can convert debt to equity or shares in the company as part of the agreement, or if the loan repayments are not fully repaid. The lender could also accept equity in a scenario where the borrower defaults on repayments.

Mezzanine capital is more suited to established UK SMEs with ambitious growth plans rather than fresh start-ups. Finance partners will be looking for evidence of years of growth, sustainable operating profits and a robust, forward-looking business plan.

This form of financing is often used in management buyouts and commonly in property development where lenders are investing with an eye on the mid to long-term. But, increasingly, mezzanine funds are lending to SMEs.

How does mezzanine financing work?

Mezzanine financing is often used to complement other forms of funding on projects. A common scenario is as a kind of ‘top-up’ loan following the agreement of a majority investment from other senior lenders.

One of the important things to understand about mezzanine financing is how the debt sits in the level of seniority. The mezzanine finance sits beneath the senior loan in the hierarchy of a company’s capital structure. In other words, the mezzanine debt is only repaid once the senior debt obligations have been met.

Bear in mind that the future ownership of your company could rely on the success of your growth plan. If your revenues stall and you struggle with repayments, you may end up ceding some control and ownership of your company to your mezzanine lender as debt is converted to equity.

What are the costs of mezzanine financing?

The interest on mezzanine financing is typically much higher than on more traditional UK loans. Interest rates above ten per cent are normal and sometimes as high as 20 per cent. Why so high? Remember that this kind of finance carries a significant level of risk for investors as the debt is subordinated below the senior obligations.

If the business does well, mezzanine finance providers will receive their high-interest repayments. Furthermore, in some arrangements, the lender will receive equity even if the loan is paid back (with a larger share received in the event of default), meaning your success increases the value of their stake in your business. Interest payment schedules are flexible and can be made monthly, quarterly or annually depending on the individual arrangement.

Another factor that can have an impact on company accounts is that the interest on mezzanine finance debt is tax deductible.

In addition, some finance arrangements allow borrowers to defer repayments and roll them back into the overall debt to repay it later.

Finally, in the event that the business plan is successful and you experience the growth you hoped for, there is sometimes an option to restructure mezzanine funding into a form of more senior debt at a lower rate of interest.

How long does it take to secure mezzanine financing?

As mezzanine financing is quite a complex arrangement it can take a while to arrange. It may take several weeks, more likely several months. Remember, this kind of financing is normally applied to complement a major growth project, so extended arrangements should be factored into broader business and financial planning.

What type of security do I need for mezzanine financing?

Security is not always needed for mezzanine financing, as the lender can receive equity in the company through certain lending conditions in the arrangement or if the borrower. Therefore, in many cases, the borrowing company needs to put up little additional security.

However, in other cases, UK mezzanine finance providers may require additional collateral or personal guarantees. This depends on the individual circumstances of the finance application.