FINANCIAL BASICS: DEBT, EQUITY AND MEZZANINE FINANCE
1. Debt is money borrowed by one party, say a company looking to raise funds to expand into new regions, from another party, say an investor, who in turn will make money by lending to the company by earning interest on the amount of debt. From a lender’s perspective, debt can be a form of investment since it earns interest and increases the original sum. 2. Like debt, equity is a “source of funds” for a borrower, like a company. The differences between debt and equity as sources of funds are the terms and conditions attached to each. If a business is raising money and uses equity as a source of funds, it is effectively giving up a share of ownership to an investor, who buys a stake in the company and that amount is then used by the company to expand its operations. Thus, equity represents investors’ stake in a company. 3. You may have heard of a mezzanine floor in a building – that intermediate level between two floors? Mezzanine finance is just like that – it’s an intermediate kind of finance that is a hybrid of both debt and equity. It can be tricky to understand as it is a catch-all phrase, and it can describe many types of instruments that are not quite pure debt or pure equity.
Mezzanine finance is essentially debt, but is either more expensive (because mezzanine lenders are willing to take on a little more risk), or requires less collateral (assets that are used as security that the lenders can claim in case the company doesn't pay). In addition to paying cash interest, many mezzanine structures include options or warrants which the investor can exercise, and hence gain equity or ownership in the company.