For both buyers and sellers of businesses, the availability of capital can sometimes be the only bridge to bring a transaction to completion.  Banking institutions operate in a low risk frame of mind.  They lend capital in a secured environment, in first or senior position against the assets of an entity, usually well below market value. 

As successful businesses are not just valued by assets alone, the additional funds beyond what a senior lender may be willing to provide must come from the buyer, seller or another third party with a higher threshold for risk. The part of the purchase price that reflects the value of cash flow that appears to be recurring or predictable is commonly referred to as goodwill. How a buyer pays or how a seller receives consideration for this component depends on the marketplace.

The most common desire that a seller of a business wants is all or as much cash as he or she can receive up front to reduce his or her future exposure. On the other side of the table, the buyer wants to do the same as the seller in reducing future exposure by putting up the least amount of cash as possible.  You may have heard that you can pick the price or terms but not both.  When financing sources dry up, cash becomes king, and he who has the cash rules the land, thereby controlling the leverage of dynamics in the marketplace. 

Mezzanine financing can level the playing field, so to speak, by becoming an important mechanism in an acquisition or sale transaction.  Mezzanine capital is the level of financing between senior debt and equity, typically issued in the form of subordinated debt or preferred stock with equity provided by a warrant, conversation feature or the outright purchase of common stock.  Mezzanine financing is capital used in business acquisitions and business sales as well as a financing option for companies in transition.  When available, a buyer may be able to pay a higher cash portion of the purchase price to meet a seller's needs with out substantially reducing his or her return on investment. 

In fact, mezzanine financing when taken together with the required equity investment has been one of the determinant factors of financial buyer’s valuations of acquisitions for over 30 years.  Most acquisition financings are structured around 1.2 – 2.0 times the earnings-to-debt coverage. The borrower is therefore able to obtain senior financing at a lower loan to-value ratio, thus decreasing the cost of such primary debt financing and providing the lender with a more favorable debt service coverage ratio (“DSCR”).

The mezzanine capital can be subordinated debt with a fixed interest rate that is included in this debt coverage ratio for a senior lender.  In the event the subordinated debt interest and structure cause the ratio to fall it can be structured as preferred stock with a fixed dividend. Mezzanine financing is also advantageous in that on the balance sheet of a company, it is treated like equity and may make it easier to obtain standard bank financing.   

The returns on mezzanine capital vary depending upon the risk associated with the investment, and usually have a fixed interest component as well as future participation.  Mezzanine financing is typically found with venture capital companies and/or alternative lending institutions seeking a higher rate of return. Typically, a mezzanine investor looks for overall returns of approximately 20 percent to 30 percent, depending on the perceived risk -- versus the 40 percent plus returns that equity investors expect.  This can be achieved with an additional interest or, most typically, equity in the form of ownership of a company.  The equity is most often in the form of warrants to purchase common stock for some extended period of time.   These warrants may come with additional conditions, such as pre-stated buy-back at a guaranteed price. 

To attract mezzanine financing for an acquisition or growth, companies usually must demonstrate:

1.     Track record in the industry, with established reputation and product.

2.     A history of profitability, or at a minimum, breaking even.

3.     A viable expansion plan for the business, whether through acquisition, broader penetration of the market, etc.

Mezzanine capital can be a risk-financing alternative that will help meet a major goal, such as an expansion, a complex transaction like a merger, or succession financing, when you pass ownership on from one generation to the next.

It's also useful to a company that doesn't want to dilute ownership by going the traditional venture capital (VC) route. Turning to sub-debt financing, for example, means a firm can get the money it needs to expand while retaining shareholder ownership. Sub-debt financing is considered a hybrid between venture capital and traditional bank lending.

HOW A TYPICAL DEAL MIGHT BE STRUCTURED

Because it can be a highly flexible form of financing, mezzanine deals vary considerably, depending on the lender/investor and the specific transaction. Much depends on negotiations and whether a lender/investor believes there is competition for his investment. “Typical” mezzanine characteristics nevertheless include:

1. An interest-only coupon that is normally higher than that encountered in senior debt currently in the 12 percent to –14 percent range. (Some funds may agree to capitalize part of their interest, to be paid at the termination of the loan, especially if the coupon is on the high end.)
   
2. No principal paid during the life of the loan, thereby significantly reducing cash outlays for the company.
   
3. Principal typically paid in a lump sum at the end of the loan, and nominally priced warrants for an equity stake in the company.– This equity stake, however, will be much less than your typical equity investor and will be negotiated based on the company’s projections to reach a target IRR (20 percent to 30 percent), for the lender/investor, including the interest coupon.

The chart below highlights major characteristics between senior lenders, mezzanine lenders/investors and equity investors.

Keep in mind, that whether you’re considering a business sale, acquisition or need growth capital, mezzanine financing may still not meet your specific needs.  However, in other situations it may be the difference between getting a transaction completed in your time frame and on the terms agreeable to the parities involved.

Mark Gould is a Vercor Partner, Master Mergers & Acquisitions Intermediary, and Certified Business Intermediary and Certified Business Opportunity Appraiser. Mr. Gould has valued companies, and has provided merger and acquisition services to a wide range of clients in many industries.