For many middle market companies, it's often difficult to obtain senior debt financing to support the growth of the business. Although the company may be three to five years beyond the start-up stage, it may lack the resources to finance sales growth or capital projects from earnings alone. The solution to this financing dilemma? The use of the hybrid debt equity investment known as mezzanine financing.
How Does Mezzanine Financing Work?
Mezzanine financing is also known as subordinated debt, which ranks below senior 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 do include success fees or warrants 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 are determined based on a multiple of earnings, or as a percentage of the company's book value or enterprise value. This structure, assuming the company performs as planned, will yield a minimum compounded annual rate of return 20% to 22% over the life of the loan.
A clear advantage of mezzanine financing is the flexibility it affords both lenders and borrowers. The parties can devise a mezzanine package that contains just the right trade-off between equity dilution on the one hand and interest charges on the other. Or, based on the company's projected earnings, the lender can calculate the amount of principal and interest the company can service, then work out with the borrower the equity portion needed to provide the investor with the required rate of return.
When to Use Mezzanine Financing
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:
Mezzanine financing can be a viable option for middle market companies seeking to support their profitable growth without incurring unreasonably high interest rates and other terms that may be unacceptable to the company's management. Your financial institution can put you in touch with the many providers of mezzanine capital in the market place to help you take advantage of this beneficial financing opportunity.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.