Why You Should Care About Mezzanine Financing
Let’s consider a typical growth company and how it might get funded. If you solely own your company, you likely have some bank debt (perhaps a revolving line of credit with a small amount of term debt).
Say you now you see a new growth opportunity. Let’s assume this growth opportunity isn’t about buying a new piece of equipment or a competing company, but rather it’s about expanding your sales and marketing dramatically. You notice that your revenue jumps when you add a new salesperson in a new geography, but that jump takes about six months to hit.
You usually start by funding these new salespeople through existing cash flow, and you notice that your credit usage ticks up as you do this. You realize that you have figured something out about your company, and you don’t want to add new sales territories slowly--you think you can add infrastructure and people all at once (or at least faster), but that will drag down your cash in the short term.
You want to stay ahead of your competition, but you need funding. And, you like owning 100%, or almost 100%, of your company, so you may be reluctant to approach a private equity fund.
What funding options are open to you?
You may be able to fund your growth the way you have been or go to your lending institution to get it done. Be prepared to show clearly how your new salespeople start paying for themselves in a reasonably short period, and your bank might fund some or all of your growth. Your receivables would eventually go up, creating more collateral for your lender, too. But another potential source of financing could be mezzanine financing.
What does a mezzanine fund look for and how does a subordinated loan work?
Mezzanine funds charge a higher rate of interest than senior bank debt, but are less expensive than private equity (thus the name mezzanine, as it fits between those layers in a capital structure). Principal payments usually come after a set time (perhaps five years) and interest payments either are due quarterly or can partially be accrued until a later date. Your bank and your mezzanine provider can create a subordination agreement to govern which payments can be made to the mezzanine lender. Most mezzanine lenders charge an upfront fee and may seek some direct or indirect form of ownership in your company (often through a warrant that can only be exercised if the company does poorly or very well). Mezzanine funds sit behind your senior bank debt in almost all cases, with less or no collateral coverage (although many take a second lien on your assets), with some priority over you as the owner of the business.
Your big decisions when seeking mezzanine are a mixture of the decisions you make when you seek senior debt and equity.
- How leveraged do you want your company to be? Mezzanine is more forgiving than senior debt because principal payments come later, but it does add leverage to your business.
- How much equity will you give up? Most mezzanine providers to smaller companies will want to be compensated for their risk by receiving some equity upside or getting the option to control more of your business if it underperforms.
Is mezzanine right for your company?
The growth opportunity you see may be something that this type of financing can help with, and help you grow faster. As with any financial instrument, you should seek out multiple providers of capital so you get a good sense of competitive pricing and so you get the best deal for your company.
A good place to start is at the U.S. Small Business Administration website, which provides information about SBIC programs. You may also want to look at the Small Business Investor Alliance, an organization for funds with a focus on smaller middle-market companies. These are all helpful resources as you look to identify ways to fund your company’s growth.
ED POWERS | Columnist | Head of Capital Access Funds, Bank of America
Based in New York, Ed Powers is a managing director and head of the Capital Access Funds team at Bank of America Merrill Lynch. Capital Access Funds is an experienced, returns-driven private equity fund-of-funds.