“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 firstname.lastname@example.org.
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Few challenges are thornier for family business owners than preparing for a transition of ownership. It’s a time for facing tough choices about the company’s future leaders and how the new owner will finance the transfer.
“About 70 percent of family-owned businesses will change hands over the next 10 years as the baby boomers retire,” says Krista Dobronos, senior vice president and Akron market leader for Westfield Bank. “Unfortunately, too many business owners have not planned sufficiently for this transition.”
At a minimum, this planning process should begin three years before the targeted ownership shift, Dobronos says, though five years in advance is ideal.
Smart Business spoke with Dobronos about transitioning family business ownership.
What elements should be included when planning an ownership transition?
About half of all family businesses don’t have any kind of succession plan on paper. The starting point should always be identifying who will take ownership of the business, whether it’s a key employee, a family member or an outsider.
A business owner should also consider to what degree they want to remain involved in the business. Do they want to remain an investor in the business or get out entirely? They also need to consider the best option for financing the ownership transition.
Exit planning isn’t only about the owner’s retirement. Ownership transitions can also be triggered by divorce, disability, an extended illness or unforeseen death.
What are some of the best financial options for family business ownership shifts?
It all depends on the company, its industry and those who will take over the company.
Some buyers may wish to pursue a traditional bank loan for the company, which is usually a seven-year term loan using a 10-year repayment schedule. The buyer of the business can also take out an individual loan that is guaranteed by the company.
When there is a gap between the purchase price of the company and the value of collateral to back a bank loan, the buyer may need to secure gap financing. Mezzanine financing, for example, is becoming increasingly popular, and usually takes the form of subordinated debt or an equity investment like preferred stock. The seller can also provide financing referred to as a ‘seller note’ for the buyer to cover that gap over a period of time.
What about transitioning ownership to a company’s employees?
An employee stock ownership plan (ESOP) can successfully finance an owner’s exit strategy, but it requires a longer planning process than other financing options.
An ESOP is a way that an owner can transition shares of the business to the company’s employees at a lower after-tax cost, providing employees an opportunity to build wealth.
How can business owners take emotion out of the equation when planning?
It’s important to make a decision that’s based not on emotions but on the sustainability of the business long term.
This is one of the reasons it’s so important to have trusted advisers you can turn to. Sit down with your attorney, banker, accountant, financial adviser and other professionals you trust to help you develop a sound perpetuation plan.
What do banks look for when they consider backing such an ownership transition?
With regard to the company, banks want to ensure there’s adequate cash flow to service debt related to the ownership change. Banks look at the industry the company operates in and how market forces might impact it in the future. In the new owner, banks want to see a track record of experience with that company or industry.
When considering supporting an ownership transition, banks spend time in the company’s facility or office to see them in action, observe the approach to staffing and understand their clients. This interview process is critically important for both sides. It’s like a courtship — the business owner should feel as comfortable with their banker as he or she is with them. ●
Krista Dobronos is senior vice president and Akron market leader at Westfield Bank. Reach her at (330) 668-6420 or email@example.com.
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The laws of physics tell us that what goes up must come down. The reverse is true in today’s interest rate climate. Rates that have stayed low — among the lowest they’ve been in U.S. history — for such an extended period of time will soon begin to climb.
“This is a topic that gets commentary daily in the news,” says Jon Park, chair and bank leader of Westfield Bank. “It’s easy to think that it’s just noise and that things will stay this way forever. But it won’t, and companies should take precautions now against the inevitable increases in interest rates.”
The impact rate increases will have on borrowing money is obvious. But your company also could be impacted in other, more unexpected ways.
Smart Business spoke with Park about what you should expect from the coming rate increases, and how you should prepare.
When will rates start to rise and how large might the increases be?
Experts have predicted stable rates for now, with increases beginning in 2015. Once the Federal Reserve begins increasing short-term interest rates, they will likely climb at least 2 percent over a period of 18 to 24 months.
Interest rates work in cycles. The current 0.17 percent short-term rate (one month LIBOR) is considerably lower than its 20 year average of 3.27 percent. When rates have been artificially held low for too long, they will go up. It’s like tension in a spring that has to release.
Are there ways a rate hike can impact businesses that they might not expect?
Increases in interest rates will reduce the profitability of businesses in general. Though new borrowing will still occur, loans will be more expensive. Some companies are able to pass on these costs as price increases, like utilities and other businesses that are equipment-intensive. Many businesses will need to prepare for the increased cost, as the rising rates squeeze the profit margin for themselves, and their clients or vendors.
Another unexpected consequence is that the market value of commercial real estate could slowly begin to decline. The formulas used to determine a property’s worth are based on the positive cash flow the property generates, and interest rates are one of the biggest components of the formula.
What should businesses do to prepare?
Ask your bank to convert variable-rate term and real estate loans into fixed-rate loans. Many businesses have been borrowing at variable rates because it has been cheaper. Converting to a fixed rate will cost more in the short term, but will protect against future interest rate increases.
Approach your bank about re-pricing your fixed rate commercial real estate loan. Normally these loans are re-priced at five-year intervals. You may have several years before hitting the re-pricing threshold. Negotiating to re-price the loan now could secure that fixed interest rate for another five years.
You can also purchase an interest rate swap that will allow you to convert from a variable-rate loan to a fixed-rate loan. Ask your banker about the cost and terms involved to swap rates.
Finally, consider extending the term and/or renewal extension options of any real estate lease. Higher interest rates will eventually translate into higher rent payments, since interest expense is one of the largest cost components for real estate investors and landlords.
Are there other ways companies should prepare themselves from an operational perspective?
Finance your expansion now. If you need to buy a new drilling machine or update your computer system, take advantage of these low interest rates prior to the expected rise.
It is a prudent time to consider your process for accounts receivable. When interest rates are low, many companies aren’t as strict about payment terms. But as interest rates rise, it will be more important to collect your cash quicker and extend your payables longer. Plan ahead and implement the right strategy now.
This is a good time to make sure you have trusted financial advisers on your side to help you prepare for the coming interest rate hikes. ●
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