Merchant Banking Meaning: What It Is and How It Works

A business wants to grow. It needs resources, and the question arises where to obtain them. In corporate finance there is the concept of merchant banking. It is not about loans but about raising capital and structuring deals aimed at development. Read this article and you will understand how it works in practice. 

What Is Merchant Banking

Meaning of Merchant Bank

It is a financial institution that helps a company obtain money for development through financing rather than traditional loans. For a business, the sources of growth become funds, the issue of private equity, and structured deals. Merchant banks offer advisory services and financial services that support corporate development.

Such a bank can underwrite securities, support transactions that involve security placement, and participate in private placements as part of its work with corporate clients. A merchant bank may also act as an intermediary when a company needs expert guidance.

This type of organization provides primary advantages:

• some merchant banks could participate in equity investments, but this is not a universal feature and varies by jurisdiction and licensing;
• it advises on mergers and acquisitions, restructuring, and the placement of shares and bonds, offering specialized advisory services;
• it structures complex deals, often with an international component, helping to reduce risks;
• merchant banks may manage and underwrite securities issues where permitted by local regulation.

Clients of a merchant bank are typically medium sized businesses and large corporations that have outgrown standard banking products. Merchant banks generally work on smaller and more private transactions than large global investment banks, though the exact thresholds vary. Merchant banks also provide specialized support that also helps companies choose the right method to raise funds.

Merchant Banking vs Commercial Banking

The main differences appear in functions, clients, and objectives.

A commercial bank focuses on routine money operations. These include accounts, payments, deposits, and basic credit. Commercial banks gives services designed for daily liquidity and standard needs.

Merchant banking is different. It concentrates on financing, deal structuring, and capital raising. Merchant banks serve companies that need strategic support, not only day to day financial services. Merchant banks offer a wide range of solutions connected to growth and complex decisions, while these banks handle everyday operations.

With this difference in mind, the functions of a commercial bank can be summarized as follows:

• opening and maintaining business accounts;
• carrying out payments and transfers;
• accepting deposits from companies and individuals;
• issuing loans and overdrafts based on collateral or credit history;
• supporting daily liquidity and basic settlements. 

These functional differences naturally attract different clients.

Merchant banking typically works with medium and large corporate segments that already require more advanced solutions. Commercial banking serves a wide spectrum, from small businesses to large enterprises, focusing on standard operations.

Their goals differ as well. A commercial bank ensures stability of daily work, while merchant banking supports long term development and helps companies access the right form of financing.

You may also want to explore the distinction between acquiring and issuing banks in more detail. We cover this topic separately in our article Acquiring Bank vs Issuing Bank: What’s the Difference, which explains their roles, responsibilities, and how they interact within the payment ecosystem.

Key Functions of Merchant Banks

Core Functions of Merchant Banking

Their role is to act as a strategic financial partner. Merchant banks provide financial and advisory services that help companies grow, manage risks, and use capital more effectively. The functional areas are defined through the following points:

1. Establishing a link between companies and sources of capital. 
2. Forming an objective understanding of the potential and risks of new initiatives.
3. Providing reliable data so that parties can make well-informed decisions. 
4. Helping structure transactions and allocate capital according to interest and risk profiles.
5. Supporting a balance between profitability and sustainability in corporate decisions.
6. Forming the optimal capital structure inside the company.
7. Assisting corporate changes and transfers of ownership.
8. Strengthening transparency and accountability in corporate governance. 

In this way merchant banks serve an important role in the system and provide services to help large corporations and other clients make solid decisions.

Merchant Banking Activities and Services

This type of support is often seen as a turnkey solution. In practice, merchant banks offer a wide range of activities and specialized services designed for complex situations. The typical set of services includes:

1. Financial advisory work: assessing the business, building a financial model, choosing a capital structure, and selecting the right instruments for raising funds. 
2. Underwriting and the placement of securities: when a company issues shares or bonds, the merchant bank can underwrite the issue, organize the book of orders, and communicate with investors.
3. Organizing purchase or combination deals: the bank helps a business find a company to buy or merge with, checks financial indicators and documents, and evaluates potential profit. 
4. Financing major projects: helping a company gather funds from different sources and structure the terms so the project can start and the funds can be repaid. 
5. Restructuring advisory: preparing a plan when a business faces debt pressure or a change in ownership structure, and coordinating it with creditors. 

Often this is a combined package of services that depends on the specific characteristics of the company.

How Merchant Banking Works

At each stage of work the role of the merchant banker is different.

Step 1. A need for financing or a deal appears

First, the company has a specific task: expand production, enter a new market, attract investors, or buy another business. A standard loan is no longer enough, so the management looks for a partner that will help raise funds and properly structure the deal. Merchant banking refers to this kind of support when a bank acts as an intermediary between the company and capital.

Step 2. Contact with the merchant bank and initial assessment

The company approaches a merchant bank. The bank collects basic information: financial statements, development plans, and ownership structure. At this stage the specialist evaluates whether it is realistic to obtain the required amount and which tools may be suitable. If the prospects look reasonable, the parties sign an agreement on cooperation. Merchant banks help companies at this early stage to understand what type of financing and what structure they really need.

Step 3. In depth analysis of the business and choice of a financial solution

Profitability, debt burden, risks, and growth potential are examined. Based on these data, the bank proposes a form of financing:

• private placement of shares among investors;
• issue of shares or bonds;
• a combination of debt and capital;
• a deal to buy or sell a company.

The choice of instrument depends on the task. If long term and stable capital is needed, the focus is usually on a share in the business. If the owners do not want their stake to be diluted, the bank selects debt instruments.

Step 4. Preparing the structure of the deal and the documents

Once the format is chosen, the technical work begins. It is connected with:

• building the structure of the deal and distributing roles;
• assessing risks;
• preparing financial models and forecasts;
• creating information materials;
• agreeing legal schemes with consultants.

The goal is to structure the deal so that it is clear to investors, meets legal requirements, and suits the company in terms of conditions. In many cases this stage is seen as issue management and detailed preparation of documentation.

Step 5. Search for investors and negotiations

After the materials are ready, the bank approaches potential investors. These can be funds, private capitalist, or industry specific companies. The merchant bank presents the project, answers questions, gathers interest, and records preliminary terms. If there is sufficient interest, negotiations start. 

The parties discuss the amount, the stake, timing, and restrictions. The bank coordinates the process, because the way the dialogue is built often defines whether the deal will be closed and on what terms.

Step 6. Final agreement and closing of the deal

When the parties reach agreement, the merchant bank helps:

• prepare legal documents;
• agree on payment terms and the schedule for contributions;
• set up settlements through accounts and escrow, if this is required. 

After signing the documents and fulfilling the conditions, the money is transferred to the company. At this moment the financing is formally raised and the deal is considered closed.

When a business starts accepting electronic payments, the topic of merchant banking intersects with the concept of merchant payment: this is a payment that a client sends to a business through online or offline channels with the involvement of payment infrastructure.

Step 7. Post deal support

The work does not always end here. The merchant bank:

• monitors the fulfillment of financial conditions;
• helps the company report;
• if necessary, takes part in further financing rounds or new projects. 

If the bank has received a share in the business, it is interested in the company’s growth and in the execution of the plan, so post deal support becomes part of a long term partnership.

Merchant Bank Account and Client Operations

A merchant account is part of payment acquiring infrastructure and is unrelated to merchant banking services.

When a business connects a merchant account, it can work through different payment gateways and aggregators that combine several payment methods in one interface. This allows the company to accept cards, electronic wallets, bank transfers, and other methods without having to interact directly with each bank or payment system.

Client operations are the operations related to clients, such as buyers, that pass through this merchant account. They include payment authorizations, clearing, refunds, and settlements.

Merchant Banks and Investment Banks

Key Differences Between Merchant and Investment Banks

The difference between a merchant bank and an investment bank appears in the types of deals they manage and the companies they support.

An investment bank works with large market transactions. For clarity:

• Preparation for an IPO. This is an initial public offering when a company sells its shares on an exchange for the first time to any interested investors. The investment bank prepares the documents, evaluates the company, and supports the listing process.
• Public offerings of shares and bonds. The bank organizes the sale of securities on the open market, where capitalists buy them directly through exchange mechanisms.
• Major purchase and sale transactions. An investment bank joins when a deal is so large that it must be taken to the international level.

Considering these functions, it becomes clear that investment banks mainly work with institutional capitalists such as funds, insurance companies, and asset managers. They operate with organizations that invest large amounts and use only verified public instruments. Their task is to bring companies to a large public arena so that the market can buy their securities.

The difference from a merchant bank is that merchant banks serve medium sized or large but not fully public companies that need targeted capital for development. Merchant banks include services that prepare a company for specific growth needs, while investment banks work with large scale public operations. Merchant banks may also provide private placement and direct advisory services that do not require a public listing.

Modern companies also use acquiring systems and merchant accounts to manage client payment flows, which complements their work with both merchant and investment banks.

Real-World Example of Merchant Banking in Practice

A manufacturing company that plans to build a new factory and expand into international markets. However, their own funds are insufficient, and the cost of a traditional bank loan is high, limiting their flexibility. They decide to turn to a merchant bank.

Here’s how the process works:

1. Business Analysis: the merchant bank analyzes the business, evaluates the potential return on investment, and assesses the acceptable level of debt.
2. Proposal of a Deal Structure: the bank offers a deal structure. Part of the funding comes through the issue of bonds, while the other part is raised through private placement of equity shares among institutional investors.
3. Financial Advisory: the merchant bank becomes a financial institution that provides consulting throughout the process. It helps the company prepare necessary documents and assists in negotiating terms.
4. Underwriting: if needed, the bank can underwrite the securities issue, taking on some of the risk to ensure the offering is successful.
5. Partnership: the bank may choose to invest some of its own capital in the company, building a long-term partnership.

This process may enable a company to access additional forms of capital beyond traditional bank loans.

Merchant Banking Services in India

The Indian market is actively regulated by the Securities and Exchange Board of India (SEBI). In India, merchant banking is governed by specific rules known as the SEBI (Merchant Bankers) Regulations, 1992. These regulations provide clear guidance on the functions, registration, and operation of merchant banks in India.

Some key features of regulation in India are:

1. Mandatory registration with SEBI: to operate as a merchant bank, an entity must be registered with SEBI and meet the required standards.
2. Minimum Capital and Infrastructure Requirements: merchant banks must meet a minimum capital requirement and have the necessary infrastructure and qualified staff.
3. Services Permitted: merchant banks are limited to providing a specific set of services, such as managing securities issues, offering corporate finance advice, and providing other related consulting services.
4. Increased Disclosure Requirements: the SEBI regulations ensure that merchant banks maintain transparency, particularly in small and medium-sized IPOs. The regulatory body has increased due diligence and information disclosure requirements.
5. Ongoing Supervision: SEBI conducts both pre-registration checks and ongoing monitoring to ensure compliance. Violations may result in sanctions or restrictions on new mandates.

In the coming years, SEBI is expected to continue revising its rules to enhance investor protection, increase transparency in securities offerings, and broaden the role of merchant bankers in developing the financial market, including through instruments like REITs and InvITs (Real Estate Investment Trusts and Infrastructure Investment Trusts).