Mezzanine financing, also sometimes referred to as subordinated debt or financing, is a rarely used but viable financing option for small businesses in search of capital for rapid growth. Under this arrangement, an 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," wrote Lawrence M. Levine in Business Credit. "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-term 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, pension funds, and banks.
Business experts point to mezzanine financing as a particularly provocative financing option for some companies that have moved beyond start-up status but do not yet have the wherewithal to finance big growth moves themselves or via traditional lending arrangements. Indeed, Juan Hovey observed in Nation's Business that mezzanine financing owes its very name to the fact that "it raises growth capital for firms that are well beyond the start-up stage but not yet far enough off the ground to go public." Entrepreneurs launching start-up 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 securing business expansion funding. Certainly, the amounts that can be raised via mezzanine financing are substantial. According to Private Placement Leter, mezzanine financing raised more than $820 million in 1996 for companies of all sizes, and other sources place the amount considerably higher. Larger companies account for some of this activity, but analysts indicate that even modest-sized companies ($10-12 million in revenues) can expect to raise as much as $15-$20 million through this route. As one investment executive told Nation's Business, "a company can leverage two to three times its cash flow in senior secured debt. It can raise total debt to four to five times cash flow with a mezzanine deal. So if the company is doing $2 million in cash flow, it can probably raise $4 million to $6 million in senior debt and $4 million to $5 million more in mezzanine financing, for a total debt of $10 million, or five times cash flow."
Most experts believe that the use of mezzanine financing will continue to grow among both small and large companies. "More and more U.S. companies are committed to financial restructuring in order to create the incentives to maximize business value," stated mezzanine investment executive Robert F. Perille in Corporate Cashflow Magazine . "In addition, as our economy has become increasingly service-oriented and entrepreneurial, thousands of excellent companies no longer meet the asset-based formulas of commercial banks. These companies need financing to grow or facilitate a change in ownership, but they do not want to issue relatively expensive equity. This growing demand, coupled with an increasing supply of mezzanine capital from a diverse base of institutional investors, will assure mezzanine financing a place in future capital structures."
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," explained Hovey. "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 your 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. As Levine stated, "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," indicated Perille. "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."
As with most other types of financing, mezzanine financing includes both benefits and drawbacks for the small business owner.
Brooks, Rory, and Jim Read. "Mezzanine Gains Ground." Investors Chronicle. October 21, 1994.
Campbell, Katharine. "Development Capital is Industrial Strength." Financial Times. December 2, 1997.
Gross, Kent, and Amin Amiri. "Flexible Financing with Mezzanine Debt." Journal of Business Strategy. March-April 1990.
Hoogesterger, John. "Economic Trends Boost the Fortunes of Mezzanine Funds." Minneapolis-St. Paul CityBusiness. August 25, 2000.
Hovey, Juan. "A Little-Known Pathway to Growth." Nation's Business. March 1998.
Levine, Lawrence M. "The Role of Subordinated Debt in Financing." Business Credit. May 1995.
"Mezzanine: Refusing to be Overshadowed." Acquisitions Monthly. June 1998.
Perille, Robert F. "Mezzanine: Efficient Financing for Recapitalization or Rapid Growth." Corporate Cashflow Magazine. May 1996.