Debt, Equity, Mezzanine finance: Understanding the different investment routes

With many businesses eager to pursue growth in new markets and increase exports, the ability to navigate the complex funding landscape is essential in making ambitious plans a reality and unlocking the potential to deliver crucial contributions to UK’s economy.

There isn’t one route that suits all when it comes to assessing the right funding options; there are many twists and turns and forks in the road depending on sector, business model, speed of growth and strategy. Therefore, the first step to a business’ financing journey is understanding the types of investment available.

Estimates of the amount of un-invested capital sitting within UK debt and private equity funds vary. But the amount probably runs into the hundreds of millions. With British banks remaining cautious when investing in mid-market businesses, decision makers should certainly include alternative investment funding in their search for finance.

Debt, equity and mezzanine finance are the three broadest, and most widely available types of alternative funding on offer, and their benefits and drawbacks are outlined here:

What is Debt Finance?

• Borrowing an amount that is paid back with interest by a future date
• Can be in the form of a secured or unsecured loan
• Often used for working capital or acquisitions

A popular funding option, debt finance is based on the underlying concept of a lender providing capital in exchange for repayments and interest until the principal loan is repaid after a specified amount of time. The capital is usually secured against the business or its assets, often in the form of a debenture.

Debt finance doesn’t typically require the business to relinquish any equity, which is an attractive feature for business owners looking to maintain control. Repayments can be structured based on the strategy of the business, making it an ideal option for businesses that may have lumpy or seasonal cash-flows intrinsic to their business models.

There are now a range of product options available spanning traditional loans, loans from challenger banks and more varied options such as asset-based finance offered by alternative lending companies. While traditionally, debt funding was perceived as having a difficult conversation with a bank manager, there are now a plethora of routes available as providers continue to make waves in this exciting marketplace.

Pros – why you should consider debt investment:

• Growing number of options available depending on the age, assets and ambitions of a business
• Business owners retain control and all aspects decision making
• Highly suitable for businesses with a strong balance sheet and a diverse client base
• Offers predictability for a business’ cash-flow, with repayment terms and interest set out from the outset

Disadvantages with debt finance, however, is that business security is likely to be needed, sometimes lenders will also look for personal guarantees from business owners or majority shareholders. Failure to keep up with repayments could result in the loss of assets. Despite their attempts at endearing themselves back to the British public and the corporate world in general, the banks remain at best reasonably consistent in their lending policies. Many are clearly looking to reduce exposure to the SME sector and it’s clear that credit functions are having an increasing influence over the discretion of front-line relationship bankers to lend.

Cons – things to think about:

• There will be a checklist of criteria a business will need to meet before being accepted
• Debt is often secured against assets which will be at risk if debt repayments fail
• Fixed terms mean a business must repay all debt and interest within a given timeframe

Business owners should look to explore their options and find a deal that suits them, firstly by examining the funder’s history and any additional support offered by them e.g. via public sector growth programmes and secondly for the interest rates and terms of the contracts available. Debt funding has a higher level of structure than equity, such as the value and frequency of repayments and the fixed term length, all which will have an impact on a business’ bottom line in the years following investment.

What is Equity?

• Selling shares to an investor in return for capital
• Investment not secured against assets
• Often lends itself to higher risk early-stage businesses

Equity finance is acquired by selling shares of a business to an investor in return for capital. A key benefit of bringing a new stakeholder onboard is their invested interest in seeing the business succeed. It’s worth looking for equity investors that can offer specialist insights, resources, connections, and guidance to increase the firm’s value. This kind of investment doesn’t leave a business with any debt to repay, easing financial pressure.

Although some businesses may have reservations about seeking equity-based finance, especially as this means a dilution in the ownership and control of the firm, for some it is this rapid injection of investment that can best propel them to new heights.

Pros – why you should consider equity:

• Lends itself to start-ups/early-stage businesses or those with a high reward potential and higher risk profile
• Doesn’t require high-value assets to secure finance against
• It doesn’t necessarily demand a long record of trading or business success

Equity funds bring a requirement for staged growth and ultimately exit plans to provide a return for the equity investor, equity finance only works for some businesses and the direct involvement in the business plans by external investors is not for everyone.

Cons – things to think about:

• Dilution of business ownership and decision-making authority
• Success and ultimately profits must be shared with investors

All above, decision makers must think carefully about the type of equity they seek and who from. Screening venture capital providers, angels or private investors for their expertise, experience and the lifecycle of their previous deals will help to gauge not only if they are an appropriate partner, but will answer pertinent questions such as: do they turnaround their businesses quickly for a fast profit, or do they work with their investees long term?

For most, it’s the human side of equity investment that provides the difference – does the investor have invaluable industry insight that could drive the business forward, could they act as a non-exec director or advisor?

What is Mezzanine Finance?

• Also known as the hybrid, combining debt and equity
• An agile counterpart to its alternative counterparts

Mezzanine investment has recently emerged as a viable alternative to pure private equity, providing a layer of debt in leverage transactions, but more importantly as a significant source of growth capital in the SME market.

Sometimes known as the hybrid, mezzanine finance combines elements of both debt and equity funding to form an agile alternative to its counterparts. Using equity as a form of collateral, lenders can offer more finance compared to what borrowers could get via wholly debt lending.

Priced to reflect the increased risks over debt, mezzanine finance is a flexible source of funding with extended repayment terms with limited shareholder involvement compared to that of pure equity deals. It is a promising option for firm’s that are experiencing large scale investment from a senior debt provider such as a bank, but not enough to cover the entire package. Mezzanine finance often plugs this gap and enables the deal, such as a high value management buyout, to occur.

Pros – why you should consider mezzanine funding:

• Offering the flexibility of less frequent repayments compared to traditional pure debt
• Less shares are handed to the investor compared to pure equity deals
• Often used for large-scale growth plans such as acquisitions and buyouts

Mezzanine finance is senior to equity but subordinated to pure debt (meaning it sits in the middle when it comes to a repayment order). This however means that compared to a pure debt transaction, Mezzanine is a more expensive form of debt due to higher interest rates but is seen as a cheaper form of equity.

Cons – things to think about:

• Like equity, shares of the business will need to be handed to investors
• In the long-term, more interest will be paid in comparison to pure debt investments
• Some loan agreements may include restrictive covenants, limiting how other debt is refinanced or additional investment borrowed

In conclusion, whether it be debt, equity or mezzanine finance, business owners looking to capitalise on the growth opportunities open to them in the coming years must take advantage of the increasingly supportive, flexible, and diverse funding landscape. Whatever the need and the growth plan, finding the right investment can be the catalyst to seeing a business reach and exceed its potential.