Structured Equity vs. Mezzanine Equity: Which is Right for You?

Last updated on October 10th, 2024 at 03:13 pm

Financing a new business and making an investment have one thing in common: the number of options can be daunting. There are many options to consider, research, and select. If you’ve ever been interested in financing a business or investing, you must be familiar with these terms: structured equity and mezzanine financing. These are some of the top choices in the field.

In this article, we will help you reduce your research load by giving you details on how these options differ from each other so you can make a more informed decision. Let’s start with the basics here:

What Is Structured Equity?

Structured equity is a hybrid financing tool for businesses that helps them raise capital through the market. It has the features of both equity and debt instruments. Structured equity is a very flexible financing option that can be customized to benefit both the business owner and the investors. The flexible nature makes it less risky, with a moderate growth potential, making it a balanced financing and investment option.

Structured equity often includes features like preferred returns (which means you get paid before common shareholders) or convertible components (which let you turn your investment into equity down the line). This type of financing is more suitable for situations like buyouts, recapitalizations, and mergers, where the firm has to raise capital with a balanced debt and equity approach to avoid giving too much power to the investor in company decisions.

READ MORE Structured Equity 101: What Investors Should Understand

What Is Mezzanine Financing?

Mezzanine financing is also a hybrid tool that falls between debt and equity, but in this case, the tool leans more towards debt features. This type of financing is more suitable when the firm has to make some big moves and needs extra cash for expansion, acquisitions, or other significant changes. It’s called “mezzanine” because it’s positioned between senior debt (like bank loans) and equity in terms of risk and repayment.

When a company raises capital using Mezzanine financing, they are to pay regular interest to the lender. However, the lender also has the option to convert their capital into company equities if the company can’t pay it back or reaches a certain milestone. This can give investors a nice profit but also increase the risk.

In a way, mezzanine financing is like a loan with benefits. It gives companies the funds they need without immediately giving up equity, but it’s riskier for investors because it’s lower in the repayment priority list.

READ MORE 7 Key Differences Between Structured Equity and Traditional Equity Every Investor Should Know

Structured Equity vs Mezzanine Financing

1. Risk Factor

Structured equity is a safer option than mezzanine financing because of its flexible and customizable nature. Investors who put their capital in this type of equity often have some safety features in the agreement, which protect them from heavy losses.

On the other hand, mezzanine financing has a more riskier profile. In Mezzanine finance, the investors are repaid after all the other debt obligations have been paid off. This makes it a risky option because if the company doesn’t have enough left to pay back everything, repaying other debt obligations, the investors might not get enough. This makes it a very risky option.

2. Flexibility

As discussed, structured equity is a very flexible option, which means it can customized in a way that benefits both the company and the owner. The agreement can be modified to satisfy the needs of both parties, whether that’s adjusting the repayment schedule, adding conversion features, or customizing priority in the capital stack.

In contrast, mezzanine financing is not flexible at all. The terms of the agreement are strictly to be followed without any compromise. The investors are to be paid back on time, and the interest payments are to be regular. If the business misses the payment, it can create a tricky situation for the investors.

3. Return Potential

Structured equity offers a more moderate return on investment. As the financing is a mix of debt and equity, it offers the security of debt instruments and the growth of equity. With this mixed approach, the return potential is capped. However, with time, investors can convert their capital into pure equity for more profits.

On the other hand, mezzanine financing offers more dynamic and higher returns for its higher risk factor. Investors receive interest payments regularly and an equity kicker (which could be warrants or options to buy equity). With regular interest payments, mezzanine investors can see significant gains.

4. Ownership and Dilution

Structured equity is an option that firms use when they don’t wish to give too much decision-making power to the investors. The agreement usually states that the investors will get paid as per the company’s performance, but they don’t have much say in the company’s decisions. This is done to preserve the authority within the firm and keep the firm’s visions intact. However, with the customizable nature of this equity, the firm may preserve the authority for the starting period, but they have to dilute later on the line when the investors start switching their investment into equities.

Mezzanine financing has warrants or options in the agreement that allow the investors to switch to equity whenever they wish. This means that with growth, many investors can convert their stakes in the company into equity, leading to more diluted ownership.

5. Priority of Repayment

Structured equity stands in the middle of the line when it comes to receiving payments. They come after senior debt holders and before common shareholders.

Mezzanine financing investors are way back in the line when receiving the interest payments. Mezzanine financing is subordinate to senior debt holders, which is why the investors get paid after all of the firm’s other debt obligations are fulfilled. Due to this, mezzanine financing is considered a very risky option because if the company is liquidated, these investors might not get paid.

6. Control and Voting Rights

Structured equity has limited control and voting rights for the investors. Mostly, investors who wish to have some involvement in management decision-making have it added into the agreement to ensure they can have their say when significant changes are to come, like mergers or acquisitions. However, these rights are not as influential as the rights and control of traditional equity investors. This makes it more favorable to the firm because it preserves the power of decisions inside the firm.

Investors don’t have much say in mezzanine financing either. However, it can change if the company fails to pay the investors on time or misses their payment. Investors gain additional authority and influence over the company if they fail to meet their obligations to the investors. If the situation worsens, investors can also step in to protect their investment, but other than these instances, their control is limited.

7. Costs and Terms

Structured equity is a more cost-effective option in the long run. The flexible nature of the equity helps the business to reduce its financial stress if needed. For instance, structured equity investors may agree to delayed payment or less return if the firm’s cash flow is disturbed.  

Mezzanine financing, on the other hand, is more costly. If the company fails to pay or misses even one payment, the financial burden on the firm keeps increasing. The cost can increase quickly if the firm also has more investors or other financial obligations.

READ MORE 7 Fundamental Differences Between Structured Equity and Preferred Equity

Frequently Asked Questions (FAQs)

Final Statement

At the end of the day, deciding between structured equity and mezzanine financing is all about your goal and risk capacity. Structured equity offers more flexibility that helps the business and investors to mitigate some risks and burdens. It’s a great option if you want a more balanced approach. Meanwhile, mezzanine financing is a high-risk, high-reward approach. This one is more for risk-loving investors who love gambling and earning big. For companies, this option can give you quick cash without giving away ownership immediately.

For investors looking to find the right balance between risk and reward, structured equity is the choice. The mezzanine is the way for investors who want to earn big and are willing to risk it.

For companies, you should know what the firm needs and can handle, but with your understanding of the differences now, I’m sure you will make your decisions more confidently.