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Expert Answers to Biz Questions

Listen in! Pick up some expert advice to a reader's question that we selected from CyberSchmooz.

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Loan vs. Equity vs. Mezzanine financing: which is better for your business?

 

Imagine your business urgently needs funds, and you get the following financing options:

  1. A bank wants to loan you the entire amount at a fixed interest rate of 5 years
  2. A business contact wants to give you the entire amount but wants a certain percentage of the business
  3. An angel investor colleague wants to give you all the money but wants to receive an interest, as well as a percentage of the business.

Which would you choose?

Wait… wait…. Wait. Before you answer that, why not read this article till the end? At least, so you can know what you’re getting with your choice.

Oh, and in case you didn’t notice, option #1 is what you’ll call a loan, option #2 will qualify for equity funding, and option #3 is more or less mezzanine debt financing.

 

Loans for business: Pros and Cons

When it comes to business financing, loans are the first option people run to. But are they really the best option? Let’s find out.

Pros of Loans

  1. Your equity remains intact

One of the biggest perks of loan financing is that you won’t be trading the ownership of your business.

  1. Steady stream of cash flow

Whether you want to fund a new project, acquire new equipment, or expand your workforce while waiting for your customers to pay up, you can easily take loans to stay afloat.

  1. Large sum of money

There is no limit to how much loan you can take. Provided your business has sufficient credit to access it.

Cons of Loans

  1. It is hard to qualify for

You may struggle to find a lender willing to borrow you money.

  1. Huge paperwork

If at all you do find a lender, it might take a while to get your loan approved.

  1. Repayment can hurt your cash flow

Paying back to the lender will definitely reduce the amount of spare cash you have for the loan period. Meaning you may not be able to push other stuff like expansion, new acquisition, etc., until the debt is done.

  1. They’re sometimes secured against an asset

Failure to repay a loan can result in the lender seizing your asset.

Equity funding: Pros and Cons

This one refers to an angel investor coming in to fund your business without requesting any repayment in return. However, he asks for a certain percentage of your business.

Pros of equity funding:

  1. No interest, No repayment

You won’t pay back any money you receive.

  1. Zero liability

Even if the business fails, you won’t be obliged to pay back the investor. It’s their loss.

Cons of equity funding:

  1. Give up ownership or a part of it

The biggest drawback of equity funding is that you lose a certain percentage of your business to people that didn’t begin the whole journey with you.

What this means, in practice, is that you no longer have the final say over your business operations, and you don't own the entirety (100%) of profits. You will share profits with them according to an agreed percentage, and they can argue/contest some of the business decisions you take.

Mezzanine Financing: Pros and Cons

This type of financing is a hybrid of loan and equity financing. That is, it’s a type of financing option that combines debt-like features with equity-like features.

How does Mezzanine financing work?

How it works is that you take out a mezzanine loan from a lender (like a traditional loan). Then you start paying back a certain sum, maybe monthly or quarterly.

However, it differs from traditional loans because it is typically interest-only, with the principal due at the end of the loan term. But in the event you fail to repay the loan fully or default in interest repayment, you may have to give out a certain percentage of the business (equity) to the lender. This is where the equity-like features come in.

Pros of mezzanine financing:

  1. Access to a huge amount of funds

If banks are unwilling to offer the amount of money your business needs, you might easily find a mezzanine lender willing to meet your target funds.

  1. Lower equity loss

Unlike outright equity financing, mezzanine financing may not even reach the point where you have to give out your business equity. And even if you have to, the percentage is usually not as significant as regular equity financing, which means you'll still have higher control over your business.

  1. Doesn’t hinder you from applying for other financing options

Most lenders may not be willing to borrow you money if they see you're currently servicing a traditional loan. Luckily, Mezzanine financing doesn't show up as a loan. Instead it appears as equity on the balance sheet, enabling future borrowers to think you aren’t servicing any loan.

  1. Flexible repayment structure

You can choose to pay interest charges with cash, add them to the loan balance, or provide equity-like instruments to the lender.

  1. Lower liquidity

In the event the business fails, mezzanine lenders won’t trouble you. At least, not until you’ve settled all traditional lenders you’re obliged to.

Cons of mezzanine financing

  1. Higher interest rate

Mezzanine lending usually comes with hefty, double-digit interest rates. Most times, you’ll find interest rates in the region of 15%-20% or above.

  1. Not ideal/accessible for every business situations

You may not find a mezzanine lender for all of your business situations. In fact, most lenders only consider it for situations involving:

  • Recapitalizations
  • Leveraged buyouts
  • Management buyouts
  • Growth capital
  • Acquisitions
  • Shareholder buyouts
  • Refinancings
  • Balance sheet restructuring

 

  1. Might lose equity

If you default on payment, you might lose a certain percentage (control) of your business.

Conclusion

Now that you’ve seen how they all compare, which do you think is best for you? Sleep on it and make a calculated decision. But be sure whatever decision you make is in the best interest of the business.

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