Mezzanine Financing Primer

By MICHAEL CARTER

Mezzanine capital is funding that is junior to less risky traditional bank financing, and senior to high-risk equity financing. Examples of mezzanine financing include: subordinated debt, convertible debt, and debt with warrants.

Advantages

Flexibility - A mezzanine investment can easily be tailored to a company's particular financial situation and concerns. Mezzanine financing balances the interests of the investor and the company. Issues that are negotiable and that are interrelated include: amortization schedule; percent of equity dilution; current interest rate; collateral; future value of the company; and puts and calls, to name a few. For example, Carter Morse & Company recently raised a $1.5 million mezzanine loan where the company did not want any equity dilution. Impossible? Given the strong outlook for the company's earnings, the lender was satisfied with 5% of the company's earnings for the life of the loan.

Cost - Mezzanine financing is less expensive than the traditional equity investment. The primary expense is the equity dilution, which varies per transaction, but is often less than half of what an equity placement would require. Other cost benefits include the low transaction costs relative to a public offering, which are often over 10% of funds raised. In addition, interest is a tax-deductible expense, as opposed to dividends, which are not tax-deductible.

Increased Capital Base - Banks and suppliers view mezzanine debt as quasi-equity under most conditions. Banks feel more comfortable for two reasons: a deep-pocketed investor is now financially committed to the business; and the margin for error has increased.

Investment Criteria

Competent, experienced, deep management team
Strong, consistent cash flow
Low technological risk
Strong market position
Low capital requirements

Structure
Typically, mezzanine financing is structured as unsecured long-term debt with an "equity kicker" in the form of warrants to purchase equity, or conversion rights into common stock. The debt will amortize over 5 to 7 years, earn a current interest rate of 13% to 15%, and contain terms and conditions, some of which resemble bank covenants, and some equity conditions. A put, the right the investor has to be paid in full, typically is made at the end of Years 5 to 7.

Investor Profile
The major investors in the mezzanine market are:

Mezzanine funds
Venture capital funds
Insurance companies
Small business investment companies
Commercial banks

Situations

Mezzanine capital is often utilized in the following situations:

Your bank is at its comfort level and will not lend beyond a certain point.
Public equity financing is not available due to the present IPO market and/or company's track record, industry, or growth prospects.
Equity financing is not available in the private marketplace because investors want a greater equity percentage than you are prepared to give up.
The venture capital market doesn't view your company as a rapid growth situation.

You believe your company will experience rapid appreciation in the next few years. Therefore, instead of selling undervalued equity today and receiving a low price, you can use mezzanine financing to bridge the company until it proves itself in the marketplace. At that point, you can sell stock for a higher price.

Pricing

Investors receive their return in the form of a current interest rate and an "equity kicker." The lower the current yield, the higher the equity kicker. Targeted internal rates of return average between 20% and 30%, depending upon the investment and the investor's objectives.

One extremely flexible feature can be performance targets that affect the percentage of equity the investor earns. For example, Carter Morse & Company was involved with a mezzanine investor that doubted the company's optimistic earnings projection. The investor was willing to give back 5% of its equity in 1990 and 1991, if the company met its earnings projections in those years. Because the company was confident it could reach its projection, it didn't mind agreeing to a higher than expected percentage from the start.

The internal rate of return calculation is based on the amount invested. The average investment for a $5 million investment with no amortization is $5 million; the average investment with equal amortization over five years is $2.6 million. Therefore, the first investor will require double the return that the latter investor would require. Clearly, if a company is able to amortize the investment, less equity dilution will result.

Two critical items that need to be negotiated are puts and calls. Puts are the investor's right to be paid in full; calls are the company's right to buy back the investment. From the pricing point of view, the key question is how to value the investment at this time. Fair market value is often the variable, which can be de- fined by numerous methods, including: multiple of earnings or sales; independent valuation; stated dollar amount; or simply by negotiation.