What Is Mezzanine Financing – Hybrid Funding Option Explained

Key Takeaways

• Mezzanine financing is an option for businesses to raise funds using a hybrid (debt + equity) approach. 
   
• Mezzanine financing is an ideal option for companies that are raising funds for a particular project or acquisition and have maxed out their bank limit.
   
• Mezzanine financing has various features such as higher returns, flexible design, no heavy collateral, and many more. Such features make it attractive to both investors and the companies.

Mezzanine financing serves as hybrid financing, mixing traits of loans and equity. Usually, this comes into action when a business has already borrowed as much as banks are willing to lend, but it still needs additional money.

Suppose XYZ company needs ₹12,00,00,000 to set up a new manufacturing plant. A bank is ready to lend ₹8,00,00,000 as secured debt. However, the company still needs ₹4,00,00,000. 

XYZ company decided to raise ₹4,00,00,000 through mezzanine financing. The lender charges 18% p.a and also has the right to convert the loan into shares if the company cannot repay. The following table shows the total repayment of the XYZ company:
 

In case XYZ company fails to repay (₹6,88,00,000), then the lender can take equity instead of waiting for repayment. In this blog, we will learn more about mezzanine financing, its features, benefits, and potential risks involved. 

Why Do Businesses Use Mezzanine Financing?

A lot of times, companies face situations where bank loans are not enough. Also, issuing new equity seems too costly because it dilutes ownership. In such a situation, mezzanine financing helps the companies bridge this gap by:

• Offering larger capital than unsecured loans.
   
• Providing flexible repayment terms.
   
• Allowing businesses to delay equity dilution unless absolutely necessary.
   
• Giving stronger returns to investors in comparison to what standard debt provides.

This flexibility makes mezzanine financing highly attractive during acquisitions, expansions, or buyouts. 

Bonus Tip: The term ‘mezzanine’ is derived from the Italian word mezzano, meaning ‘middle’. This accurately captures mezzanine financing’s place in capital structure, located between equity and senior debt. It offers repayment security along with a chance of equity conversion.

Key Features Of Mezzanine Financing

The following table lists the major features of mezzanine financing:
 

The above-mentioned features show that mezzanine financing offers more security than equity and greater earning potential than traditional debt.

Sample Capital Structure Of A Company

A company’s capital structure usually consists of equity, mezzanine financing, and senior debt. All these sources do not carry the same level of risk or reward. Each layer in the capital structure has its own place, ranging from safe senior debt to high-risk equity.
 

This layered structure shows how mezzanine financing balances repayment priority with attractive returns. This makes it a true middle ground in funding.

Benefits Of Mezzanine Financing

This method is popular as it provides benefits to both businesses and investors.

For Businesses:

Mezzanine financing provides the following benefits to the businesses:

• It provides additional funds without immediately giving away equity.
   
• Interest paid is tax-deductible, reducing effective cost.
   
• It fills the gap left after bank loans.

The above-mentioned benefits make mezzanine financing attractive to companies.

For Investors:

Mezzanine financing provides the following benefits to the investors:

• They earn higher returns compared to secured loans.
   
• They have an option to convert into equity if the company grows.

The above-mentioned benefits make mezzanine financing attractive to the investors. 

The following table provides a summary of the benefits of mezzanine financing for businesses and investors:
 

The above-mentioned advantages make it popular among both sides.

Potential Risks Of Mezzanine Financing

Mezzanine financing surely has many benefits, but it also has some risks.

For Businesses:

Mezzanine financing has the following potential risks for the companies:

• High cost of capital due to interest rates between 12 to 20%.
   
• Pressure of repayment can strain cash flows.
   
• If unable to repay, they may lose part of ownership.
   

Before opting for mezzanine financing, the companies must look out for the above-mentioned risks.

For Investors:

Mezzanine financing has the following potential risks for the investors:

• Repayment happens only after senior debt, making it risky.
   
• Recovery depends on the company’s performance.

As an investor, you must keep the above-mentioned risks in mind.

The following table provides a summary of potential risks for the companies and the investors:
 

The above-mentioned risks might make this option unattractive to some companies or investors.

When To Consider Mezzanine Financing?

Businesses usually turn to mezzanine financing when they need funds beyond what traditional banks offer but do not want to dilute too much equity. The following table shows situations in which you can consider mezzanine financing:
 

From the above-mentioned table, you can see that mezzanine financing suits firms that are ready to grow but cannot rely solely on bank loans or equity. It acts as a bridge, giving businesses both flexibility and access to larger funds.

Final Thoughts

You might have understood by now that businesses often see mezzanine financing as a useful middle option. They can secure funds without giving away full ownership or relying only on traditional loans. 

Mezzanine financing balances risk and reward by sitting between debt and equity. This offers higher returns and gives companies more flexibility.

It generally comes at a higher price than secured loans. However, its unsecured nature and tailored terms make it attractive for growth-focused firms.

If you are planning to opt for this option for your business, then you must weigh repayment capacity, future expansion, and investor expectations before choosing this route.

FAQs

1. What are the two main types of financing?

The two main types are debt financing and equity financing.

2. How is mezzanine debt treated in company accounts?

Mezzanine debt is shown as a liability, but because of its equity-like features, it may also appear under hybrid financing.

3. What is the intercreditor agreement for a mezzanine loan?

It is a contract that defines the repayment rights between senior and mezzanine lenders.

4. What is the maturity of a mezzanine debt?

Mezzanine debt typically matures in 5 to 7 years.

5. Do investors in mezzanine financing get voting rights immediately?

No, investors usually don’t get voting rights at the start; rights apply only if debt converts into equity.

6. What is the difference between venture capital and mezzanine financing?

Venture capital funds early-stage companies, while mezzanine financing supports later-stage firms ready for expansion.

7. What is the difference between a mortgage and a mezzanine loan?

A mortgage is secured against property, while a mezzanine loan is backed by company equity or ownership rights.
 

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