Consider Some Middle Level Financing

Consider Some Middle Level Financing

If your company is mature and you are looking for financing to bring it to the next level, but you don’t want to go public and are unwilling to give up any control of your business, mezzanine financing could be for you.

Mezzanine financing —  also known as subordinated debt, junior debt, structured equity, and equity-linked notes — can be particularly useful when your capital needs exceed what your senior secured lender and your equity holders are willing to provide.

Mezzanine Applications

 Mezzanine financing can be a good option if your company has exhausted such secured financing as term loans based on capital assets, or short-term financing based on current assets.

In addition, because this type of financing helps preserve cash flow needed for daily operations, it can be particularly useful if you are raising capital to:

  • Boost market penetration;
  • Improve research and development;
  • Expand payroll;
  • Broaden distribution;
  • Finance marketing programs;
  • Increase inventory;
  • Acquire equipment;
  • Expand geographically, and
  • Develop export markets.

Other reasons to consider subordinated debt include:

  • Management buyouts and succession planning;
  • Leveraged buyouts;
  • Acquiring intangible assets such as intellectual property;
  • Strategic mergers and acquisitions.

What It Costs

This type of financing is a hybrid of debt and equity that lenders expect to generate a 20 per cent to 30 per cent return through capital appreciation and interest. With that expected return, mezzanine financing is not cheap.

First, the lender advances cash through a term loan at interest of between eight per cent and 12 per cent. The interest payments, paid regularly over the term of the loan, are tax-deductible.

Then the lender enhances the rate of return with an “equity kicker,” which is usually some form of participation in the expected success of your company.

These participation features can take the form of royalties on sales; a percentage of net cash flow; participation fees; warrants or options to buy shares, and rights to convert debt into common stock.

And finally, origination fees generally run between two per cent and three per cent of the transaction, although in some cases the lender may waive the fees.

Mezzanine lenders don’t really want an interest in your company, so instead of holding real assets as collateral, as is the case with equity loans and venture capital financing, mezzanine financers prefer rights to convert their stakes into ownership equity should your company default on the loan. As a result, the debt doesn’t dilute your equity stake and you retain control of the business.

Getting in and Getting Out

Given that cash flow and the success of your business account for much of the lenders’ return, they typically will want to see that your company has a sound track record and management team; a history of profits; strong margins; an established line of credit, and a strong business plan. Start-ups and businesses with financial difficulties need not apply.

The lenders will also want a clearly defined exit strategy, which could involve selling the company, recapitalizing, refinancing, or even an initial public offering.

One disadvantage of mezzanine financing comes from its position on your company’s balance sheet.

Subordinated debt is sandwiched between senior debt and equity. So, in the event of bankruptcy or the sale of your business to pay debts, proceeds first would go to pay off senior lenders, then subordinated lenders. Your common and preferred shareholders would come last and likely receive a much smaller share of those proceeds.

A Borrowing Advantage

On the other hand, a mezzanine layer in your financing could help your company raise more total capital.
For example, say you wanted to make a $100 million acquisition through bank debt and equity. The bank might lend you $50 million, leaving you with an equity requirement of $50 million.

If you added mezzanine financing, the bank might lend just $40 million, but the subordinated lender might provide $25 million, for a total capital of $65 million. Your equity requirement then has dropped to $35 million.

Moreover, banks often look more favourably on companies that have institutional backers and may offer more attractive credit terms.

Your financial advisor can discuss the merits of mezzanine financing and help determine if it would be an ideal solution for your company’s growth needs.

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