For many closely held private companies, it’s often difficult to obtain senior debt financing to support the financial needs of the business. Although the company may be well beyond the start-up stage, it may lack the financial resources to fund sales growth, new product or market developments or capital projects. The use of hybrid debt/equity investment known as mezzanine financing can be a viable solution to this financing dilemma. Recent market conditions have re-established mezzanine financing’s appeal as a tax-efficient source of long-term capital. With the reduction of traditional senior bank credit and the reluctance of banks to lend under the lenient terms and low rates offered over much of the last decade, mezzanine is one of the more effective vehicles for owners of closely held private companies interested in facilitating liquidity for wealth diversification or succession purposes, pursuing acquisitions, or funding organic growth.
Mezzanine finance has long been a component in creating the optimal capital structure for companies, but its importance has increased dramatically within recent years. Inflexible bank criteria have significantly increased the demand for mezzanine finance. In fact, mezzanine finance is now often the difference between successfully bridging the gap between equity and senior loan funding or losing a transaction.
Mezzanine financing, also known as subordinated debt, ranks below senior debt (typically bank debt), but above equity in priority of payment. When a company determines that it’s not capable of financing its growth plans with senior debt, the first step is to partner with a financial institution to locate an investor willing to provide capital in the form of long-term subordinated debt, usually carrying a fixed interest rate. Generally, these loans do not involve ownership or management participation; however they typically include success fees or warrants for the lender/investor to purchase equity at a later date. Most buy-back provisions for success fees or warrants are structured to give the investor more than just one type of payoff. In most deals, the value of the warrants is determined based on a multiple of earnings, or as a percentage of the company’s book value or enterprise value.
Companies in one or more of the following situations should consider mezzanine financing as an attractive supplement or alternative to senior debt or straight equity financing:
- Due to recent losses, or heavy indebtedness, the company has good growth prospects but cannot raise new senior debt without first getting additional subordinated/mezzanine financing;
- The company has adequate cash flow to service a certain debt load, but has a lack of lendable collateral that prohibits its bank from providing financing on a senior debt basis only;
- Management can obtain senior debt but only by agreeing to pay an unacceptably high rate of interest, accept covenants that are too restrictive, provide personal guarantees, or put up more collateral than the company owns or chooses to put at risk;
- Management can raise capital by selling equity but investors either are unwilling to pay what the owners consider a fair price or are asking for too much equity;
- The company’s expected growth and prospects for going public are insufficient to attract venture capital.
The benefits of mezzanine capital include:
- Non-amortizing, resulting in improved cash flows;
- Source of flexible long-term capital as mezzanine investors are more equity-oriented than senior lenders, they tend to be more amenable to customizing their investment to meet the borrower’s financial, operating, and cash flow needs;
- A less expensive, tax-advantageous alternative to equity.
Mezzanine financing offers other benefits to companies focused on optimizing their capital structures and expanding access to funding. Since mezzanine capital providers take a long-term view of a company, banks may look at firms with institutional investors in a more positive way, extending credit with more attractive terms and relinquishing the need for personal guarantees. Additionally, mezzanine investors help diversify a company’s funding relationships, reducing dependence on any one investor or lender. Harvest CFO Consulting can assist your company to determine if mezzanine financing is appropriate for your situation and also beneficially structure the financing with investors.
