- Senior debt vs. junior debt. Senior debt is debt that has priority of repayment in a liquidation, and, therefore, is usually lent at more competitive interest rates than junior debt.
Typically, 50 percent to 70 percent of a mid-sized company’s capital structure is senior debt. It can be extended on a secured or unsecured basis and may or may not carry the guarantee of the owner(s). Junior debt is either unsecured or has a lower priority or repayment on the same asset or property as senior debt.
- Cash flow lending. Cash flow lending, a form of senior debt, is typically extended to companies that generate significant cash from operations each year, but may not possess a great deal of balance sheet assets, such as a service company.
The leveraged buyouts of the past have set the stage for this type of lending, where financial institutions may extend credit based on a multiple of a firm’s cash flow. For these purposes, cash flow is typically defined as the borrower’s earnings before interest, taxes, depreciation and amortization (EBITDA).
- Asset-based lending. Asset-based lending, another form of senior debt, is a good choice for highly leveraged/undercapitalized companies, companies with seasonal revenue, or businesses that generate more working capital and assets than cash flow.
Many are surprised by the interest rates that are competitive with traditional business loans. Because this type of lending is based primarily on a company’s short-term assets, lenders can extend credit to businesses with higher-risk profiles.
- Second-lien loans. Second-lien loans have emerged as a mainstream solution for growing companies needing liquidity. Favorable pricing, an active mergers and acquisition market and increased use of recapitalizations have fueled this increase. These loans are junior in collateral rights and have higher interest rates.
Companies use this option to bridge the financing gap between cash flow and equity, particularly following a merger, acquisition or recapitalization. Second- lien borrowing is also a way to monetize your investment in your company during strong economic times by cashing out, replacing equity or refinancing subordinate debt through a recapitalization.
- Mezzanine loans. Used to finance a company’s expansion, an acquisition, a dividend payment or stock repurchase, a mezzanine loan typically is unsecured and considered junior debt with a longer payment term than other loans. Mezzanine loans are characterized by quick turnaround with minimal due diligence and little or no collateral. These loans are priced with the lender seeking an 18 percent to 22 percent return on its investment.
A typical structure would be a six-year loan with no principal payments until the maturity date, an interest rate of 12 percent and an equity interest to potentially yield the returns cited above.
- Equity investments. Instead of a loan, you can raise money by selling common or preferred stock to individual investors. In return for this equity investment, your investors receive ownership interests in your business, such as shared profits, a seat on the board of directors and input into how your company operates.
To help you decide what financing best meets your needs, it is important to work with a lender who is willing to take the time to understand your business and has access to and experience in all available options. No matter which options you choose, working with a trusted business adviser can provide ideas, advice and solutions that can help your business achieve its goals.
This summary is not legal or financial advice, and does not purport to be comprehensive. Please consult your own adviser. Any reliance upon this information is solely and exclusively at your own risk.
Joe Meterchick is senior vice president for corporate banking in Philadelphia for PNC Bank, National Association, member of The PNC Financial Services Group Inc. Reach him at (215) 585-6810.