Mezzanine financing, also sometimes referred to as subordinated debt or financing, is a rarely used but viable financing option for small businesses in search of capital for rapid growth.
Under the mezzanine financing arrangement, an entrepreneur borrows some of the money that he or she requires to execute the next stage of company growth (whether through acquisition, expansion of existing operations, etc.), then raises additional funds by selling stock in the company to the same lenders.
Mezzanine debt is usually unsecured or junior debt that is subordinate to traditional loans or senior debt. Subordinated debt is an extremely flexible form of financing because they are more concerned than senior lenders about their overall yield, mezzanine lenders are very liberal in tailoring their investment to meet the financial, operating, and long-term cash flow needs of the borrower. As long as the subordinated lender’s anticipated yield is satisfied, they can be flexible as to the amortization of the loan and the interest rate.
Major sources of mezzanine financing include private investors, insurance companies, mutual funds, and banks.
Business experts point to mezzanine financing as a particularly provocative financing option for some companies that have moved beyond start-up status but do not yet have the wherewithal to finance big growth moves themselves or via traditional lending arrangements.
Mezzanine financing owes its very name to the fact that it raises growth capital for firms that are well beyond the start-up stage but not yet far enough off the ground to go public. Entrepreneurs launching start-up businesses, though, should be aware that this method is not viable for them; lenders willing to make this kind of deal will require prospective borrowers to show a proven record of substantial cash flow before they will even entertain the idea.
But for growing companies with a strong cash flow, mezzanine financing may be the answer to securing business expansion funding. Certainly, the amounts that can be raised via mezzanine financing are substantial.
Through mezzanine financing a company can leverage two to three times its cash flow in senior secured debt. It can raise total debt to four to five times cash flow with a mezzanine deal. So if the company is doing $2 million in cash flow, it can probably raise $4 million to $6 million in senior debt and $4 million to $5 million more in mezzanine financing, for a total debt of $10 million, or five times cash flow.
Most experts believe that the use of mezzanine financing will continue to grow among both small and large companies. As our economy becomes increasingly service-oriented and entrepreneurial, many good companies no longer meet the asset-based formulas of commercial banks. These companies need financing to grow or facilitate a change in ownership, but they do not want to issue relatively expensive equity. This growing demand, coupled with an increasing supply of mezzanine capital from a diverse base of institutional investors, will assure mezzanine financing a place in future capital structures.
HOW MEZZANINE FINANCING WORKS
In a mezzanine financing arrangement, the borrower negotiates an arrangement with a lender wherein the necessary capital is secured by combining a loan with a stock purchase to the lender.
As a rule, you pay only interest on the money you borrow for five years or so. At that point, the business owner cash out their investors by going public or by recapitalizing their business in a new round of financing. Your investors, meanwhile, have earned interest on their loans, and if the value of your business has increased, they realize capital gains by selling their stock in your company.
Lenders that review mezzanine financing requests closely examine several facets of the prospective borrower’s business when weighing the deal. The most important consideration examined by a mezzanine lender is the company’s capacity to generate cash flow. In addition to cash flow, lenders also examine ownership flexibility, company history, growth strategy, and acquisition targets (when applicable). Business owners in need of capital, meanwhile, should do some comparison shopping of their own.
ADVANTAGES AND DISADVANTAGES
As with most other types of financing, mezzanine financing includes both benefits and drawbacks for the small business owner.
- Even though the owner loses some independence, he or she rarely loses outright control of the company or its direction. Provided the company continues to grow and prosper, its owners are unlikely to encounter any interference from their lender.
- The flexibility of the arrangement is often a big plus; mezzanine financing offers considerably more flexibility to structure coupon, amortization and covenants to accommodate the specific cash flow requirements of the business.
- Lenders who are willing to enter into the world of mezzanine financing tend to be long-term investors rather than people looking to make a quick killing.
- Mezzanine lenders can provide valuable strategic assistance. Subordinated debt advisors often bring fresh insights to businesses because they are financially sophisticated and have a great deal of experience developing strategies to maximize long-term value.
- Mezzanine financing increases the value of stock held by existing shareholders, even though they will not have as great an ownership stake.
- Most importantly, mezzanine financing provides business owners with the capital they need to acquire another business or expand into another production or market area.
- Mezzanine financing does require the business owner to relinquish some measure of control over the firm. This can be difficult for entrepreneurs who have built a promising business in no small measure because of decision-making styles that run heavily toward independence and daring. Moreover mezzanine investors with long-term incentives like co-investment plans or carried-interest plans, which provide their professionals with a meaningful stake in the business, are more likely to be there for the long term and take a partnership perspective. Finally, entrepreneurs should consider that lender of mezzanine funds will have a vote on the company’s board of directors and significant abilities to take decisive action if the company does not meet its financial projections.
- Subordinated debt agreements may include restrictive covenants. Since mezzanine lenders usually do not have any direct security interest in the assets of the borrower, lenders typically incorporate restrictive covenants into the loans that the borrower has to abide by; these include agreements by the lender not to borrow more money, refinance senior debt from traditional loans, or create additional security interests in the assets, as well as the various financial ratios that the borrower must meet.
- Similarly, business owners who agree to mezzanine financing may be forced to accept restrictions in how they spend their money in certain areas, such as compensation of important personnel (in such instances, a business owner may not be able to offer above-market packages to current or prospective employees). In some cases, business owners have even been asked to take pay cuts themselves and/or limit dividend payouts.
- Mezzanine financing is more expensive than traditional or senior debt arrangements.
- Arranging for mezzanine financing can be an arduous, lengthy process. Most mezzanine deals will take at least three months to arrange, and many will take twice that long to complete.