When to Consider Mezzanine Capital

Pros and Cons of Mezzanine Capital

by Terry Stidham, President of Target Search Group

There are a number of situations in a business for which mezzanine capital may be appropriate. The following three examples would be good candidates to consider mezzanine financing:

1. Two equal partners have run a profitable business for many years and now one wants to retire and the other wants to continue working for at least another 5 years, but he does not have the money to buyout his partners interest.
2. There is a profitable, growing business that could grow much faster if it had the capital necessary to increase the amount of inventory maintained; but, the bank is only willing to advance 50% of the cost of such inventory. 
3. The president and senior management of an established, profitable company has an opportunity to buy it, but the sum of the cash that they are able to invest plus the amount that their bank is willing to lend is not enough.

Mezzanine capital is the middle (or “mezzanine”) layer of capital between the senior debt provided by banks and equity provided by stockholders. Accordingly, mezzanine capital is generally subordinate to bank financing, meaning that the bank loan has a first claim on any of the assets of the business and generally has a right to be repaid before the mezzanine capital. On the other hand, mezzanine capital is senior to the company’s equity.  Most mezzanine capital comes in the form of a loan that is secured by all of the assets of the business (in subordinate position behind the banks). However, in some instances, mezzanine capital can also be in the form of preferred equity without any collateral or requirement to receive current dividend payments. Such equity usually has a requirement that it be redeemed prior to any payments to the company’s common equity.

 

Banks will typically require that their loans be secured with assets of the company, mezzanine capital providers generally focus on the cash flow generated from the operations of the business. Accordingly, the most important aspect of a company looking to obtain mezzanine capital is that they have a proven track record of generating cash flow from their business. This generally disqualifies start-ups and turnarounds from being good candidates for mezzanine capital. In addition, how the company plans on using the capital is important.

 

As the three examples above indicate, using mezzanine capital to fund:

• Recapitalize the company
• Inventory build-up
• Facilitate a management-led, leveraged buy-out

are all good examples of when mezzanine capital is most helpful.

 

A company seeking to establish a sales and marketing organization, to cover operating deficits or to provide partial liquidity to an owner that remains active in the business are more appropriately funded with equity.

 

Return expectations are correlated with risk:

For this reason, it is best for a company to maximize each type of capital in the order of their cost. Accordingly, only after a company has obtained as much bank debt as the bank will provide (including a revolving line-of-credit and term loan) should it consider mezzanine debt. Then, only after a company has obtained as much mezzanine debt as the mezzanine capital provider will provide should it consider mezzanine equity, and so forth. Utilizing this financing strategy will minimize the company’s cost of capital and allow the company’s owners to retain ownership of as much of the company as possible.

 

The actual cost of each type of capital will depend on many factors as well as the amount of capital required.  Economies of scale apply to capital, as they do to almost all supplies. The more capital the company needs, the cheaper the cost of the capital.  Those businesses requiring in excess of $10 million will most likely pay less for their capital than a company seeking less than $10 million. This is because there are so many capital providers competing for the over $10 million deal size. One reason for so many providers to that segment of the market is because they all have a lot of money to invest; and, since the amount of effort to find, underwrite and close a large deal is not much different than it is for a smaller deal, they prefer to spend their time on the larger deals. There are still many choices of mezzanine capital providers for loans under $10 million, but the cost is slightly higher.

 

For mezzanine debt of $10 million or less, expect to pay origination fees of 1% to 3%, a current interest rate of between 12% and 16% and options to purchase equity in the company (referred to as detachable penny warrants) so that the capital provider’s total annual rate of return on their investment will be between 20% and 25%. There are many less providers of mezzanine equity of $10 million or less; but, if you can locate one, expect to pay between 30% and 35% annually for their equity investment. These yields are still less than institutional common equity investors that require more than 35% a year.

 

Advantages of Mezzanine Financing

• Mezzanine capital gives the business the ability to execute a change of control, expand or acquire a competitor
• Interest-only payment allows the company to conserve cash
• Generally there is no loss of majority control of the company
• Flexible financing can be structured to best meet the needs of the business
• Mezzanine lenders can provide strategic and financial guidance  
• Most mezzanine providers only require the right to regularly receive financial information about the company
• Mezzanine providers will accept a business with limited or no growth potential so long as the business has consistent earnings sufficient to service their debt

Disadvantages of Mezzanine Financing

• The owner may be required to give up some equity upside so the lender can achieve its required rate of return
• More costly that other forms of debt and may come with restrictive covenants
• Can be highly negotiated therefore making the process lengthy
• The lender may require a board seat (typically it would be nonvoting)

Business owners should carefully weigh all of the factors discussed above the next time they are in the market for capital. And, if they qualify, consider mezzanine capital after they have met with their banker and before they consider equity.

As always, I welcome your questions or comments. Feel free to contact me directly if you choose.

About: Terry Stidham, President and Founder of Target Search Group (TSG). Terry is a Sales and Business Development Leader with extensive knowledge of the M&A process, combined with an in-depth understanding of the constantly changing global capital markets environment. He has served as the head of entrepreneurial organizations as well as Fortune 500 companies. He specializes with mid-market companies in a diverse array of industry sectors from service and manufacturing to technical and professional firms.

Mr. Stidham speaks the language of both the seller and the buyer having vast experience on both sides of the transaction. He has been directly involved in the execution and successful closing of hundreds of investment banking and corporate finance transactions. Mr. Stidham has instructed thousands of business owners on how to prepare for a successful exit. He improves operational efficiencies leading to significant increased value.