Today, many small business owners are trying to sell or grow their businesses in this booming economy. But, more often than not, growth capital is required to achieve an owners’ growth goals. Because of the regulatory environment, many banks are reluctant or cannot lend what their customers need. Therefore, owners have to look for alternative sources of capital. The problem is, many owners aren’t knowledgeable about capital structure and how to use it to meet their goals.
Why is it important to understand a company’s capital structure?
By design, the capital structure reflects all of the firm’s equity and debt obligations. It shows each type of obligation as a slice of what’s called the “Capital Stack”. This stack is ranked by increasing risk, increasing cost and decreasing priority in a liquidation event (e.g., bankruptcy). For small corporations and pass through entities (LLCs, S-corps etc.), the capital stack is as simple as owners’ common stock/membership interests and senior debt from their local bank.
For large corporations, the capital stack typically consists of senior debt, followed by subordinated debt, followed by hybrid securities, followed by preferred equity (preferred stock) and last, common equity (common stock).
The capital stack is effectively an overview of all the claims that different players have on the business. Debt owners hold these claims in the form of lump sums of cash owed to them (i.e., the principal and interest payments). The equity owners hold these claims in the form of access to a certain percentage of a firm’s future profits.
The capital stack is heavily analyzed when determining how risky it is to loan money to a business. Specifically, capital providers look at the proportional weighting of different types of financing used to fund the company’s operations.
For example, a higher percentage of debt in the capital structure means increased fixed obligations. More fixed obligations result in less operating buffer and greater risk. And greater risk means higher financing costs to compensate lenders for that risk. Consequently, all else equal, getting additional funding for a business with a debt-heavy capital structure is more expensive than getting that same funding for a business with an equity-heavy capital structure.
Medium- and small-business owners are seeking mezzanine financing
Today, many small to medium size business owners are looking into mezzanine financing to achieve their specific goals when bank debt or other senior debt is no longer an option. Mezzanine financing serves as a means to an end. It is not used as permanent capital, but instead, used as a solution-oriented capital that performs a specific purpose and can later be replaced with a more permanent source of capital.
What is mezzanine financing?
Mezzanine financing is a form of junior debt that sits between senior debt financing and equity financing in the capital stack. It is a hybrid of debt and equity financing that gives the lender the right to convert to an equity interest in a company in case of default. It helps bridge the gap between debt and equity financing and is one of the highest-risk forms of debt. It is subordinate to senior debt, but senior to common equity.
Mezzanine financing is more expensive than senior debt but cheaper than equity. It is also the last stop along the capital structure where owners can raise substantial amounts of liquidity without selling a large stake in their companies. Mezzanine financing rates range between 12% to 20% per year.
Often, mezzanine debt has embedded equity instruments attached, known as warrants, which increase the value of the subordinated debt. It is frequently associated with acquisitions and buyouts.
Mezzanine financing can be a useful addition to a company’s balance sheet because it is a source of “patient” capital financing that requires interest-only payments, with no required principal amortization payments before maturity. During the life of the mezzanine financing commitment, a company has time to recover from the significant “event” that drove the initial financing need – be it an acquisition, shareholder buy-outs, growth financing, or other capital needs.
Mezzanine financing provides incremental leverage to facilitate a wide variety of uses. Eight of these are:
- Recapitalizations involve raising new capital to restructure the debt and equity mix on a company’s balance sheet. Mezzanine financing is used in this scenario, especially when owners want to achieve partial liquidity and maintain control of their businesses. For example, mezzanine financing can be used in situations where a group of shareholders are seeking partial or full liquidity, while other shareholders seek to remain actively involved in the business.
- Leveraged buyouts often use mezzanine financing by purchasing shareholders’ interests, such as a private equity funds or other institutional groups, to maximize their available borrowing capacity at the time of the purchase. Leveraged buyouts are typically completed by companies looking to raise large amounts of capital to support an ownership transition or significant growth event.
- Management buyouts also use mezzanine financing when a management team buys out the current owners, such as private equity or other investors, and gain control of the business. Therefore, this allows the management team to determine the direction of the company.
- Growth capital is obtained through mezzanine financing to help companies achieve their goals for organic growth, such as significant capital expenditures or constructing a large facility. Mezzanine financing is also used to enter new markets by developing new products and/or subsidiaries.
- Acquisitions are often funded by mezzanine financing where companies purchase other businesses with the goal of growing and responding to customers’ needs more quickly.
- Shareholder buyouts often use mezzanine financing for family-owned businesses that in order to increase their ownership stake, want to repurchase shares that may have fallen out of the hands of the family or from particular family members.
- Refinancings are commonly achieved by using mezzanine financing to pay off or replace existing debt to take advantage of lower interest rates and/or access better terms. Refinancing, using mezzanine financing, adds flexibility to a company’s debt capital structure, better preparing them to seize opportunities like acquisitions and shareholder buyouts.
- Balance sheet restructurings often add mezzanine financing to a company’s balance sheet. Doing so can optimize their debt capital structure, helping to fulfill debt requirements for transactions such as acquisitions and management buyouts, while giving the company time to recover from those expenses. It can also satisfy a senior lender’s requirement for a junior capital raise or create additional senior debt capacity for a business.
Mezzanine capital providers are now moving “downstream” into the lower middle-market and small businesses for companies that need raise capital beyond senior debt. Mezzanine capital fulfills an immediate need that supports the continuing success of the business.
Gary Miller ([email protected]) is the CEO of GEM Strategy Management Inc., an M&A consulting firm advising middle-market private business owners. Read more of Miller’s blogs here.
