HOW MEZZANINE FINANCING WORKS
Mezzanine financing, also sometimes referred to as subordinated debt financing, is a rarely used but viable financing option for businesses in search of capital for rapid growth. Under this arrangement, the 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 run 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 startup status but do not yet have the wherewithal to finance big growth moves themselves or via traditional lending arrangement. Mezzanine financing owes its very name to the fact that it raises growth capital for firms that are well beyond the startup stage but not yet far enough off the ground to the public.
Entrepreneurs launching startup 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 secure business expansion funding. Certainly, the amounts that can be raised via mezzanine financing are substantial. Most experts believe that the use of mezzanine financing will continue to grow among both small and large companies.
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 (at prime plus two to four points) for five years or so. At that point, you (the business owner) cash out your investors by going public or by recapitalizing your 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 their 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. Because the primary concern of a subordinated lender is a company’s ability to generate cash, if it is anticipated that the business’ cash flow is sufficient to repay the loan, it is quite likely subordinated debt can be used. 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.
In selecting a source for mezzanine financing, companies should pay attention to personnel turnover, commitment to the business, track record, and flexibility in structuring. Low turnover and commitment to the business are key because businesses rarely perform exactly according to plan. Therefore, you need an investor who understands the business and will respond consistently and appropriately.
Advantages
As with other types of financing, mezzanine financing includes both benefits and drawbacks for the 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 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.
- More importantly, mezzanine financing provide business owners with the capital they need to acquire another business or expand into another production or market area.
Disadvantages
- 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, 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 arrangements 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 prospective employees). In some areas, business owners have 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 long to complete.
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