Marsh Business Advisors, LLC
"CAPITAL"
Between Debt And Equity Lies Mezzanine Financing
By: Stuart Wm. Marsh
President, Genesee Capital, Inc.
June 4, 1993
Your company wants to expand and needs capital to do so. Your banker declined your request for a loan on the grounds that the risks were too high. Venture capitalists were not interested because the expected returns were too low. At wits end, you conclude that you are securely positioned between the proverbial rock and the well-known hard place. A decade ago you would have had no further options, but today you can tap into one of the fastest-growing segments of the capital markets: mezzanine financing.
Mezzanine capital fills the gap between low-risk, low-cost bank debt and high-risk, high-cost venture capital. Mezzanine capital gets its name from its location on the right hand side of a corporate balance sheet; on the "mezzanine" level below the debt and above the equity.
Because banks are lending only to the most creditworthy companies and venture capitalists are investing only in those companies with spectacular profit potential, the financial gap has widened considerably. Mezzanine capital funds have been the result. In 1992, venture capital funds raised $2.5 billion of new money for investments, and mezzanine funds raised almost one-third as much at $786 million.
In addition to the new mezzanine funds such as the Midwest Mezzanine Funds, Cigna Mezzanine Partners, and Rice Mezzanine Lenders, many existing venture funds and Small Business Investment Companies provide mezzanine capital. Consult "Pratt's Guide to Venture Capital Sources" and NASBIC's "Membership Directory of Small Business Investment Companies" for a complete listing of mezzanine capital sources.
The typical candidate is a firm that is established and profitable, and has either a strong balance sheet or income statement, but not both. Bankers will lend only to companies that have both a strong income statement and balance sheet, while venture capitalists usually invest in firms with both weak balance sheets and income statements.
Mezzanine capitalists are seeking returns higher than banks because the risks are greater, and are seeking returns less than venture capitalists because the risks are lower. The rule of thumb for the cost of long-term capital is: Banks are seeking 8 percent to 10 percent per year, venture investors are seeking in excess of 35 percent per year, and mezzanine capitalists are seeking 20 percent to 30 percent.
Mezzanine capital is a hybrid of debt and equity, and usually is structured as a debt instrument with an equity feature attached. The debt instrument usually carries a term of three to seven years, and in order to assist the company's cash flow, often does not require any principal repayment during the first several years. (How do you think a banker would respond when asked for a five-year term loan with no principal repayment during the first three years? Uncontrollable laughter would be my guess.) And the amortization schedule may not call for repayment of the loan by the maturity date; a portion of the loan may "balloon" on the maturity date. The interest rate on the debt instrument is typically a fixed rate, and in today's environment it ranges from 8 percent to 14 percent. Unlike principal repayment, the Interest payments are rarely deferred.
The equity of the mezzanine investment is structured in one of two ways. One is a conversion feature that allows the principal balance of the debt instrument to be converted to equity in the company at some previously agreed upon price.
The other method is where the company grants stock options to the mezzanine capitalist. The conversion price of the debt or the exercise price of the stock options is set equal to the per-share value of the company at the time that the mezzanine investment is made.
The idea is that the mezzanine capitalist will share in the appreciation of the investee company and "exit" or "cash out" on or after the maturity date of the debt instrument. It is hoped that the equity value of the company will have increased enough, coupled with the interest on the debt, to generate the desired 20 percent to 30 percent return.
There are three ways for the mezzanine investor to exit. The investee company can go public, with some of the proceeds being used to retire the debt instrument and the public market creating liquidity for the equity. Or, the investee company can be acquired, with the acquirer repaying the debt and purchasing the equity. Or, the investee company can undergo are capitalization, where due to its improved financial performance it can replace the higher cost mezzanine capital with lower cost bank debt or with internally generated funds.
Here is an example of a typical mezzanine capital investment. XYZ, Inc. is a profitable, 5-year-old manufacturer of widgets that are sold in the United States. XYZ believes there is a huge, untapped consumer market for widgets in Europe, where recently the French and Italians went wild for widgets after Madonna used them so effectively in her latest video.
XYZ seeks $1 million to enter this market, with the money being used primarily for "soft" marketing costs and for European inventory. XYZ's banker declines the loan request on the grounds that repayment of the loan is not assured because the cash flow from the European operations is speculative, and further, there is no collateral to support the loan.
XYZ's discussions with venture capitalists prove fruitless, as they conclude that although a European market for widgets exists, it's not large or profitable enough to generate high-venture capital returns.
The venture capitalists point out that one of the largest European markets, Britain, is not an opportunity at all, as the English simply refuse to buy widgets because they are "too exciting."
Ultimately, XYZ strikes a deal with Mezzanine Venture Partners where MVP lends XYZ $1million for five years at 12 percent fixed, with no principal repayment during the first three years, and a balloon payment equal to 60 percent of the original loan amount. XYZ grants MVP options to buy 10 percent of its common stock.
The shareholders of XYZ struggle with the idea of giving up equity but felt that 10 percent was a reasonable number and that they would be much better off if the expansion into Europe was successful. By granting stock options for 10 percent of the company, the shareholders of XYZ were able to retain control, a crucial element in their decision. MVP did request one seat on the board of directors, and XYZ warmed to the idea of having their six inside directors joined by the one outside director from MVP.
XYZ discovers that it needs approval from its bank (the same one that just said no to its loan request) to borrow the money from MVP because of an additional debt prohibition covenant in the bank agreement. XYZ then seeks approval from the bank, which responds by requesting (in bankerese a synonym for "requiring," only more polite) that MVP sign a subordination agreement enabling the bank to require XYZ to suspend principal and interest payments to MVP in the event XYZ runs into financial trouble. This subordination agreement is designed to give comfort to the bank so it knows its loan payments won't be jeopardized by cash flowing from XYZ to MVP rather than to the bank.
Although the subordination agreement appears to benefit only the bank, it also benefits XYZ. Because the bank can intervene in the event of financial trouble and stop the flow of interest and principal payments to MVP, the bank treats MVP's loan as equity and not as debt. This significantly improves XYZ's balance sheet, reduces the debt-to-equity ratio, and as such, may ultimately allow XYZ to borrow more money from the bank.
XYZ and MVP agree that XYZ today is worth $5million, and there are one million shares of XYZ stock, including the 100,000 shares (10 percent) reserved for MVP, at $5 per share. MVP believes that in five years XYZ will be worth $15 million because of the $1 million mezzanine investment.
After the loan is repaid MVP will exercise its 100,000 stock options at $5 per share, sell them at $15 per share, and pocket the $10 per share profit. If this scenario occurs, MVP will generate a 23 percent annual return on its investment from the interest on the debt and the appreciation of the equity.
This 23 percent return may seem high, but consider the risks MVP are assuming. MVP's loan is probably unsecured, as XYZ's bank has a blanket lien on all assets. MVP is providing a loan where repayment is speculative. Further, MVP has signed a subordination agreement, and the debt portion may become worth less also.
Why on earth should XYZ be willing to pay 23 percent for money? A painfully blunt answer is that XYZ was unable to attract lower-cost capital, but the real answer is that XYZ's investment (its expansion into Europe) is expected to generate a return higher than its cost of capital, and therefore the investment should be made.
In this example, prior to the mezzanine investment, the shareholders of XYZ owned 100 percent of a $5 million company. Five years after the mezzanine investment, the shareholders owned 90 percent of a $15 million company. This is the creation of value; although more slices are cut, the pie has gotten larger, and everybody's piece is bigger.
There are advantages to mezzanine capital. It costs less than venture capital. It's far more flexible than bank debt. It can expand a company's borrowing capacity, and it allows current management to retain control.
A growing industry itself, mezzanine capital may help your company grow.