Is Mezzanine Financing Good For Your Business?

If you have positive cash flow and little collateral you may want to consider mezzanine finacing.

T2Systems, an Indianapolis, IN-based software company that specializes in parking management systems, wasn’t a prime candidate for a $3 million bank loan. “We just didn’t have the collateral that banks demand,” says CFO Jim Zaloudek. Instead execs turned to mezzanine financers, a provocative option for established companies that aren’t able to finance big growth themselves or via traditional lending arrangements.

As the name implies, mezzanine financing sits at the center of the business finance scale, between senior debt (bank debt) and equity financing, just like the mezzanine level of a theater is between the orchestra and balcony seats. Mezzanine lending is debt financing that usually involves a promissory note or bond for repayment as opposed to an equity investment, explains James Burk, co-author of Financing Your Small Business. 

If you have a minimum $5 million in annual revenue, operate in an expanding industry and show two to three years of rising growth, then you may be a prime candidate for mezzanine financing. Start-ups and seasonal and cyclical businesses need not apply.

Traditionally venture capitalists demand considerable equity, take a leadership role in managing the business, and require that the company go public or be sold to generate their desired 30 to 40 percent return. “[With mezzanine financing] you still own 100 percent, or most of the business, instead of selling 50 percent or more of it,” explains Burk. “You haven’t substantially diluted the equity, though you have assumed debt.” However, mezzanine financers do receive some equity through warrants, usually worth 5 percent to 30 percent of a business’ valuation

Mezzanine Financing Isn’t for the Faint of Heart
Like other types of financing, there are pros and cons to consider. What’s the major consideration?  “Overburdening yourself with debt you can’t handle,” warns Burk. Since mezzanine lenders are assuming more risk than a bank because of the lack of collateral, most want several percentage points above prime or more.

“We want to see 20 percent to 25 percent growth, but venture capital is looking for explosive growth of 50 percent to 100 percent a year,” says James Davidson, managing director of Miami, FL-based Banyan Mezzanine Fund. For example, Banyan invests in retail, healthcare and service businesses that can’t offer much collateral.

These loans can be flexible in terms of the amortization and the interest rate. Most mezzanine loans last three to five years, with the bulk of the principal often paid toward the back-end. That way small businesses can invest the money in hiring staff, developing  and expanding production, or acquiring others businesses—and pay off the loan after realizing substantial revenue gains. A $2 million loan, for example, may require a $500,000 payment in the third and fourth years of the loan, and then a $1 million payout in the final year plus the cost of the warrants.

With its $3 million loan, T2Systems hired 35 additional staff, mostly in customer service.  “That additional capacity helped us meet our increased demand and grow 150 percent compared to last year,” says Zaloudek.

Moreover, the deal was structured so that T2Systems placed the $3 million on its balance sheet as equity, and only has to make monthly dividend payments for five years. After that time it must repay the debt in full and make good on all warrants. Since T2’s business has skyrocketed, repaying the loan in five years won’t be a problem, says Zaloudek.

What do mezzanine lenders look for when considering new loan applicants? “Historical performance is the best indicator of future success,” says Robert Smith, a partner in Petra Capital Partners, located in Nashville, TN. “We want to see market growth in the industry and don’t want to invest $10 million in a $15 million market,” he added.

While most venture capitalists take a hands-on approach, many mezzanine lenders typically stand back and leave most of the business dealings to its owners and managers.  Some, like Petra Capital, look for a partner in business and require a position on the board.

Mezzanine may well also open doors to additional financing opportunities. Zaloudek believes the funding will likely help T2Systems obtain a traditional bank loan in the future. “This loan strengthened the equity portion of our balance sheet. That reduces the risk for future lenders. You reduce risk; you become everybody’s best friend.”

Key Considerations When Examining Mezzanine Opportunities
If you approach mezzanine financing thoughtfully, as you should with any loan, it can provide the capital necessary to grow your business. But before you sign on the dotted line, make sure the mezzanine lender is the right fit for you. Burk suggests asking the following questions:

• Does the mezzanine lender require the same covenant package as a bank deal and want lender liability?

• Will the lender want to put people on your board in order to exert some control?

• After the loan is issued, how closely will they scrutinize your financial statements?

• If the debt can’t be repaid, how will the lender handle it? Will it agree to restructure or refinance?

• What percentage of warrants will be required, and when can they be claimed?