Mezzanine financing - What is mezzanine financing?

Mezzanine financing is when a lender offers a loan and if the business defaults on the loan, the lender gains partial ownership of the company.

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Mezzanine financing is a mix between debt financing and equity financing. Debt financing is when a lender issues a loan to be paid back with interest. Equity financing is when investors purchase equity or shares of a company.

How does mezzanine financing work?

Mezzanine financing is the form of financing that has the highest risk. Because of this, it offers higher returns than other forms of financing, usually between 10% - 30% per year. Due to the risk, this also means that mezzanine funds are used for businesses beyond the ‘start-up’ stage.

Mezzanine financing is usually used to help fund growth or short-term projects. These funds will generally be offered by existing investors of the company. Mezzanine loans are often unsecured, meaning that no collateral is taken.

Advantages of mezzanine financing

For investors, if the business defaults on the loan, they will greatly increase their return on investment by gaining equity in the business.

For borrowers, an advantage is that the interest is tax-deductible. Mezzanine financing is also easier to manage, for instance, if the company is unable to make an interest payment, then it is possible to defer some or all of the interest. This is not possible with most loans.

Disadvantages of mezzanine financing

For the borrowing business, the owner is potentially giving up complete control over their business. Owners will also end up paying more interest than another financing method if mezzanine financing is used for long-term projects.

A disadvantage for investors is the possibility of losing their investment if the company goes bankrupt and there are no remaining assets to disburse once the senior debt has been paid.

Mezzanine financing example

Let’s say that Daniel owns a restaurant. He wants to expand the business and decides that the best financing option for his restaurant is mezzanine financing.

He approaches a lender for a mezzanine loan. Since the loan is unsecured, the lender sets out terms of the loan in the case of default.

Daniel agrees to the terms and takes a £100,000 loan by showing that the business earns £70,000 per year.

Unfortunately, Daniel defaults on the loan payment as his restaurant was unable to generate enough cash flow. The lenders then take a portion of his restaurant business and sell it in order to get their investment back.