The Basics of Mezzanine Financing
A mezzanine structure allows an acquirer to reduce the cost of capital and boost returns on equity.
When selling a business, it is highly likely that retained equity, vendor financing or an earn-out will be weighed into the purchase price. Rarely are businesses sold for all cash, which means that a portion of the purchase price is at risk. For this reason, it's important for vendors to have a good understanding of the capital structure of the business before the deal is closed. How much debt will be needed by the purchaser to fund the deal? How much equity are they bringing to the table? What other types of capital will be used to finance the acquisition?
Bond Capital Mezzanine Inc. has prepared an educational white paper titled "Mezzanine Finance" that explains the intricacies of financing instruments and capital structures. Mezzanine debt is commonly used by acquirers to finance the acquisition of mid-market businesses. This white paper provides a great introduction for entrepreneurs on how buyers use financing structures to maximize returns. Here's an overview.
What Is Mezzanine Debt?
Mezzanine debt is the layer of financing between a company's senior debt and equity. It plays an important role in providing the necessary financing in a recapitalization and management buy out, or in leveraged buyouts. Mezzanine financing is also used by cash-flow positive companies to promote growth through expansion projects or acquisitions.
Mezzanine Capital Structure
Corporate acquirers seek to use an efficient combination of senior debt, mezzanine debt and equity capital to maximize shareholder return on equity. Mezzanine financing can be completed through a variety of structures based on the availability of cash flow, the specific objectives of the transaction and the existing capital structure in place at the company. The basic forms used in most mezzanine financing are subordinated notes with warrants (for private companies), and high-yield debt (junk bonds) or convertible/preferred shares (for public companies). Mezzanine lenders look for target rates of return of 13 to 25 percent, which can be earned through current payments (such as cash interest and principal) and deferred payments (such as payment-in-kind interest, bonus payments or equity ownership). A well-structured mezzanine investment will match the business's future free cash flow with the repayment obligation and will leave excess free cash for asset replacement and growth.
A mezzanine structure allows an acquirer to reduce the cost of capital and boost returns on equity. A mezzanine investor's goal is not to be a shareholder, but to achieve a target rate of return over a selected period of time. Typically, mezzanine lending includes both a subordinated debt and equity component. The debt is usually issued with a cash pay interest of 10 to 14 percent, and maturity ranging from four to seven years. Mezzanine investors will look for a total IRR of between 13 and 25 percent. Mezzanine is more expensive than traditional debt, but it is not as strict. It is also less expensive than issuing equity where investors are targeting an IRR of more than 25 percent.
Things to Think About for a Selling Business Owner
Under the scenario that vendor financing is used as consideration in the purchase price and the buyer is obtaining mezzanine financing to complete the acquisition, a selling business owner should consider the following:
- How does the vendor financing rank in priority in the capital structure? Does it rank before or behind the mezzanine financing?
- Based on the ranking, does the vendor financing offer a sufficient rate of return for the risk that is being assumed?
- Will the company generate sufficient cash flows to service and repay the total amount of financing used to purchase the business, including any amounts owed to the seller?
About Bond Capital Mezzanine Inc.
Bond Capital Mezzanine Debt Fund is an established institutional provider of mezzanine debt and equity to small and medium-sized enterprises in Western Canada and the United States. As merchant bankers, they look for long-term partnerships with small and medium-sized businesses that are trying to find senior debt, mezzanine debt, later stage venture capital or equity to buy shares, buy assets, recapitalize and achieve other financial goals.
Written by John Carvalho | President, Divestopedia Inc.
John is president and founder of Stone Oak Capital Inc., an M&A advisory firm, as well as a co-founder of Divestopedia. For more than 20 years, John has served his clients on numerous valuation, acquisition and divestiture assignments in a wide variety of industries. John holds the Corporate Finance designation, is a Chartered Business Valuator and a Chartered Accountant. He has made it his life's mission to help entrepreneurs build valuable businesses and Divestopedia serves as an avenue for this cause.