Mezzanine finance explained for small businesses

As a small business owner in the UK, you may find yourself facing a common challenge: the need for additional capital to fuel growth. 

Traditional bank loans may not cover all your funding requirements. And, giving up ownership through equity financing might not be the right fit. This is where mezzanine finance can support your goals. 

But why should you consider mezzanine finance specifically? Well, it offers a range of benefits tailored to meet the needs of small businesses. Whether you’re looking to expand your operations, acquire another company, or even recapitalise your business, mezzanine finance can be a powerful tool.

In this article, we’ll explore the ins and outs of mezzanine finance in simple terms. We’ll also explain some key terminology, including subordinated debt and preferred equity. By the end of this guide, you’ll understand how mezzanine finance works, and why it can be a great option for small businesses. 

What is mezzanine finance?

Mezzanine finance is a structured way to borrow money for your business. It’s called “mezzanine” because it sits between the two traditional funding types – taking on senior debt, or selling equity.

Instead of seeing you borrow money, as with a regular bank loan (which are becoming increasingly more difficult for small businesses to secure these days), or sell a share of your business with equity, mezzanine finance combines the best of both worlds. In effect, it’s a mix of debt and equity that can give more flexibility to business owners.

A bank loan may have lower interest rates than mezzanine financing, but as a senior debt lender, the bank would need to be repaid first in the event of a bankruptcy. Plus, the bank has the right to sell a company’s assets to recoup the loan if the business defaults. 

Be aware, though – mezzanine finance is considered a higher-risk form of financing than senior debt or equity. Mezzanine lenders typically require a higher interest rate for this reason.

How does mezzanine finance work?

With mezzanine finance, a business can borrow money from a lender and agree to pay it back later, just like a loan. But, what makes it unique is that the lender also has the potential to become a part-owner of the business. They’re investing in the company’s success while lending money at the same time.

This hybrid nature of mezzanine finance means that the lender takes on a bit more risk compared to a regular bank lender. So, in return, they may ask for higher interest rates or even a share of the company’s future profits.

Think of it as a flexible solution that helps small businesses take that important step forward. It can give your business the boost it needs without you having to give up too much control. It’s typically a win-win situation for everyone involved – provided you are comfortable with the higher interest rates involved.

Why is mezzanine finance used?

Mezzanine finance is used by businesses that are pursuing growth, but want to preserve their ownership structure. It may also be used by those who cannot get (or do not want) a traditional loan. 

By combining elements of debt and equity, mezzanine finance provides an attractive option for businesses that require additional capital beyond what traditional bank loans can offer. It allows companies to bridge the funding gap and pursue ambitious growth plans, acquisitions, or other strategic initiatives.

Furthermore, mezzanine finance attracts the interest of private equity firms, venture capitalists and angel investors who are actively seeking investment opportunities with potentially higher returns. 

These investors are drawn to mezzanine finance due to its hybrid nature, offering both debt-like interest payments and equity-like upside potential. They provide the necessary capital to businesses in exchange for the prospect of greater returns on their investment.

Who uses mezzanine finance?

Mezzanine finance is used by a diverse range of businesses across various industries. 

Small and medium-sized enterprises (SMEs) often turn to mezzanine finance as it offers them an alternative to traditional bank loans, which may have stricter lending criteria. 

Any companies looking to finance acquisitions or recapitalise their balance sheets can find mezzanine finance to be a suitable option.

Subordinated debt explained

Subordinated debt is a key component of mezzanine finance. It’s a type of loan that works a bit differently to traditional bank loans (senior debt). 

When a business takes on subordinated debt, it means that if things go wrong and the business can’t pay back all its debts, the subordinated debt holders are lower on the list to get their money back, compared to other lenders.

Senior debt holders, like banks or other lenders, get paid back before anyone else. The subordinated debt holders then get their share. Then, if there’s still money left, the equity holders are paid back – those who own a share of the company.

Since subordinated debt holders take on a bit more risk, they usually charge higher interest rates compared to other lenders. And sometimes, the lender might also have the option to convert the debt into ownership in the company, which is called an ‘equity kicker’.

In short, subordinated debt is a way for businesses to get the funding they need, even if they have other debt obligations in place.

Preferred equity explained

Preferred equity is another key aspect of mezzanine finance. Preferred equity is like having a special type of ownership in a company. 

As a lender with preferred equity, you become an investor who is entitled to receive a fixed dividend or a portion of the profits before the regular shareholders.

In the event of bankruptcy, preferred equity holders have a higher priority when it comes to claiming the company’s assets, compared to regular shareholders. So, if things don’t go well and the company faces financial difficulties, preferred equity holders have a better chance of getting their investment back. 

However, it’s important to note that preferred equity holders usually don’t have voting rights. This means they don’t have a say in the company’s decision-making process.

Like any financing option, mezzanine finance has its advantages and disadvantages.

Pros:

• Flexible financing: mezzanine finance can fill the gap between traditional debt and equity, offering businesses more options.
• Potential for higher returns: investors in mezzanine finance seek higher returns due to the additional risk involved, making it an attractive option for those seeking potentially higher yields.
• No dilution of ownership: unlike equity financing, mezzanine finance allows businesses to raise capital without diluting existing shareholders’ ownership.

Cons:

• Higher costs: mezzanine finance generally carries higher interest rates and fees compared to traditional debt financing.
• Increased risk: as mezzanine finance involves a mix of debt and equity, businesses take on additional risk and must ensure they can handle the higher debt burden.
• Complexity: the structure and terms of mezzanine finance can be complex, requiring careful consideration and negotiation.

Mezzanine finance benefits for small businesses

Mezzanine finance offers various ways in which it can be particularly beneficial for small businesses. 

First – it can fuel growth by providing additional capital to support expansion plans. Whether the business is planning on entering new markets, launching new products, or investing in infrastructure, mezzanine finance can provide the necessary funds to drive these growth initiatives.

Second – mezzanine finance can facilitate acquisitions for small businesses. When looking to acquire another company, mezzanine finance can bridge the financing gap. This allows small businesses to leverage the assets and cash flow of the target company without diluting their existing ownership. It provides a strategic financing option to support business expansion through acquisitions.

Third – mezzanine finance can be used to recapitalise a business. It offers a way to restructure a company’s balance sheet, enabling the refinancing of existing debt or equity. This can improve liquidity, enhance financial stability, and provide the necessary resources to drive the business forward.

How to get mezzanine finance for small businesses

If you’re considering mezzanine finance for your small business, here are some steps to get started:

• Evaluate your finances: determine how much capital you require, what the funds will be used for, and how mezzanine finance fits into your overall financing strategy.
• Identify all potential lenders: research and identify lenders specialising in mezzanine finance. This can include private equity firms, venture capital firms, specialised mezzanine lenders, or even banks that offer such services. New lenders are emerging every day that also specialise to specific demographics, for example funding for female founders.
• Prepare a comprehensive business plan: craft a robust business plan that outlines your company’s strategy, financial projections, and how mezzanine finance will support your objectives. Lenders will want to assess the potential return on their investment.
• Approach lenders: Reach out to potential lenders and initiate discussions. Share your business plan, financial information, and any other relevant documents requested by the lenders. Be prepared to negotiate terms and conditions that work for both parties.

Conclusion

Mezzanine finance can be a game-changer for small businesses looking to raise capital and achieve their growth goals. It offers a unique and valuable tool that can propel your business forward.

When deciding on whether or not mezzanine finance is the best option for you, it’s important to understand how it works, its advantages and disadvantages, and how to obtain it. Take the time to carefully evaluate your specific needs, risk tolerance, and long-term financial objectives. An independent financial advisor may be essential at this stage. 

Mezzanine finance can open doors to new opportunities, but it’s crucial to weigh the pros and cons and consider your unique circumstances. With the right level of understanding, you can approach mezzanine finance confidently and chart your path toward success.

Remember above all, the key is to make an informed decision that aligns with your business aspirations.