Mezzanine financing helps companies expand or transition ownership

“Mezzanine financing is a creative option that can help companies transition or expand their businesses,” says Kevin Vonderau, Executive Vice President and Chief Lending Officer at Westfield Bank. “It’s a good choice for companies with positive cash flow that lack the collateral to cover their expansion.”

Suppose a business with $18 million in sales, $2 million in bank debt earning $550,000 in pre-tax income is owned by two equal partners. One partner decides to leave the business and offers to sell 50 percent to the remaining partner. The business is worth $3.5 million plus assumption of bank debt. To establish sole ownership of the business, the exiting owner is owed $1.75 million, and she wants a cash payment.

The remaining partner is unwilling to sell 50 percent equity stake to investors or private equity funds. The company’s qualifying collateral only supports the $2 million in secured bank debt. Where can she borrow $1.75 million and what will that do to her income and cash flow?

Bank regulators discourage unsecured lending. Numerous national banks operate mezzanine finance funds through non-bank affiliates. Often they seek mezzanine opportunities greater than $4 million and, in addition to interest rates ranging between 10 to 14 percent, they require warrants, which are rights to a percentage of ownership, allowing them to participate pro-rata in any increase in the business valuation. The $1.75 million borrowing need may be too small.

Smart Business spoke with Vonderau about mezzanine financing.

Why is mezzanine financing appealing?  

Mezzanine financing is a hybrid of debt and equity financing that can provide an opportunity to buy or expand a company when the necessary capital is not available. It allows a company to remain independent from equity investors or previous owners, which requires some management control if financing is provided. Also, it is advantageous because it can be treated like equity on a company’s balance sheet and may make it easier to obtain standard bank financing. Banks that cater to a smaller, niche market may offer mezzanine finance opportunities between $1 million to $3.5 million and total requests up to $10 million in Northeast Ohio.

How is mezzanine financing structured?

Mezzanine financing is subordinated debt and is considered higher risk lending, which mandates higher interest rates. Interest-only payments are made monthly, principal does not amortize and the debt matures typically in 4 to 5 years. Because rates are higher, borrowers are motivated to refinance into traditional bank debt as soon as possible.

Since mezzanine debt is unsecured, a pledge of company stock is required. Loan covenants are set that mirror bank covenants but with more liberal levers. The mezzanine debt doesn’t want to trip senior debt loan covenants. Typical covenants are set around cash flow coverage and cash flow leverage, which is measured by funded debt to EBITDA. Inter-creditor agreements help govern loan covenants and debtor’s rights.

How is mezzanine financing secured?

The first meeting between the business owner and the banker is fact-finding. Goals are identified as are any issues that need to be resolved to reach those goals. It can then be determined if the company needs a mezzanine partner. Companies should collaborate with their accountants, attorneys, financial planners, etc., to ensure mezzanine financing is right for them.  

How should business owners prepare?

Companies are typically evaluated by the five Cs of credit — character, capacity, capital, collateral and conditions. Mezzanine financing focuses on capacity or cash flow available to repay debt. The banker will want to understand the company’s current and projected three to five year business plan. The banker will want to know about the management team and see historical numbers to understand the company’s financial health. The more the banker knows about the company, its management team and goals, the easier it will be to help it realize its financial needs. Anytime a business has a meeting with a lender, having these facts readily available will make the process go more smoothly.

Kevin Vonderau is Executive Vice President and Chief Lending Officer at Westfield Bank. Reach him at (330) 722-8644 or [email protected].

Insights Banking & Finance is brought to you by Westfield Bank