By Rachel Byers, PhD, CPA, Accounting Faculty, Purdue Global
Published January 2016
Do you own a profitable business that is in need of capital for growth? Have you reached the maximum amount of collateralized debt that banks are willing to lend your company but don’t want to relinquish substantial equity? If so, mezzanine financing may be the answer.
In a cash strapped economy, businesses have to get creative with structuring financing deals. Mezzanine debt is an option for financing that falls between senior, collateralized debt and private equity funding. Because mezzanine debt is unsecured, subordinated debt (debt that ranks after other debt in liquidation/bankruptcy), lenders require high returns on their investment. Who might be interested in this type of capital structure? Companies looking to fund a growth opportunity like an acquisition or a new product, that’s who.
Consider a start-up company with very little invested by the original owners that has grown substantially over the course of 2–5 years using senior debt financing. The company has the opportunity for further growth and to capitalize on other opportunities, utilizing economies of scale, but has been turned down by banks because they are already highly leveraged. Private equity firms have approached the company but want substantial equity, oftentimes a controlling interest (greater than 50% equity). The owners are faced with the decision to give up half of their company in order to fund the growth and profit from expansion. That is, unless they secure a mezzanine deal.
Mezzanine debt takes many forms such as convertible debt (debt that converts to equity), subordinated debt, or preferred equity instruments. Typically, it will have a combination of cash interest payments, payable in kind (PIK) interest (interest that accrues and is added to the principal balance resulting in compounding interest accruals), and ownership options.
Continuing the example from the company described above, assume the company had a present valuation of $2,500,000. The company projects that its value will increase to $6,500,000 in 3 years if fully capitalized. In seeking $1 million in capital, the company offers the following terms:
- Interest: Quarterly cash interest payments of 5%, quarterly PIK interest of 5%
- Warrants: Stock warrants that provide an option to purchase a 5% equity stake at maturity with an exercise price set at current valuation ($125,000)
- Maturity: 3 years
Is this an attractive venture for an investor? Let’s run the numbers and see.
Cash interest payments will result in a total of $150,000. PIK interest accrues quarterly and is capitalized. For example, after the 1st quarter, $12,500 (1/4 of 5% of $1M) would be added to the principal balance. The 2nd quarter would accrue interest on that increased amount and would result in an interest accrual of $12,656, and so forth. Total PIK interest payments result in $175,264 at maturity. Assuming projections were met and the company paid the investor the market value for the stock warrants ($200,000; $325,000 less exercise price of $125,000), the investment yields a total return on investment (ROI) of 52.5%. Annual ROI would be 15.1%.
With returns like that, it is a win-win for all involved. So, will you consider using mezzanine financing to grow your business? Or, possibly, are you toying with the idea of investing in a mezzanine deal yourself?
Rachel Byers is a professor at Purdue Global. The views expressed in this article are solely those of the author and do not represent the view of Purdue Global.