Beyond bank loans: how to finance your business growth with mezzanine debt

Finance business growth without using bank loans - instead with mezzanine capitalGrowth is on the agenda of most businesses; it is also one of the primary reasons why companies look for external financing. Yet according to research from the National Center for the Middle Market and the Milken Institute, less than one-third of all small and mid-size companies are aware of nontraditional sources other than private equity (PE).

This lack of awareness can lead to a growth struggle if banks are not willing to provide enough capital and existing shareholders don’t want to part with their control of the business. This is a situation which calls for a solution that is neither purely debt, nor purely equity capital. A hybrid of these is needed and mezzanine financing is exactly the tool that is fit for the job.
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What Is Mezzanine Financing?

Similar to a mezzanine floor being located on an intermediate level between two main floors of a building, mezzanine capital sits on a company’s balance sheet between debt (bank loans) and equity (shareholder capital). It is subordinate to bank loans, thus not increasing the cost of already existing bank financing.

Typically, mezzanine loans have interest-free and/or amortization-free periods that are scheduled to match the expected cash flows of a company. This keeps the loan from being an excessive burden to the business, and also allows a company to use the available cash to realize its growth plans.

Once the growth objectives of the business have been reached, it is time to compensate mezzanine lenders for the flexible capital they have provided. At that point in time, businesses typically choose one of two options: either continue with the mezzanine loan until it is fully repaid at maturity, or make an early repayment, which relies on newly available and cheaper bank financing. In either case, the mezzanine lender usually receives compensation consisting of two components:

  • Interest earned on top of the initial capital provided, and
  • An equity kicker–or a bonus, which is linked to the increase in company’s value. The rules for calculating this bonus are defined in the loan contract.

Given that mezzanine funding is still a form of bespoke loan with some equity capital features, it is suitable for companies that can predict their cash flows with relatively good confidence. Mezzanine capital, therefore, is more commonly used by companies with established track records that want to grow and expand.

While there are other applications for mezzanine capital, such as financing shareholder transitions or restructuring debt, here will will focus on financing growth.

Finance Business Growth with Mezzanine Capital

Since mezzanine financing is always tailor-made for the needs of a specific company, it is very flexible in terms of growth paths that it can finance. Broadly speaking, there are two categories of growth strategies that are often financed with this type of capital. These are organic growth and growth through acquisitions.

Organic growth activities that are typically considered good fit for mezzanine financing include:

  • Expansion capital expenditures (capex) or, in other words, purchase of capital equipment, such as new machinery or facilities.
  • Geographic diversification or expansion of the current operations to new regions.
  • Product development; typically a company would need to be able to demonstrate more mature business from the start.

Inorganic growth strategies often include:

  • Market share increase through the acquisition of competitors.
  • Acquisition of a complementary product or service company to further foster the stability and/or profitability of the current business.
  • Geographic expansion through the acquisition of companies in the same business, but in different regions.
  • Business diversification, but only if it is justified both strategically and financially.

If you’d like to learn even more about different scenarios in which mezzanine financing can finance business growth and much more, read also Mezzanine financing example uses and investment criteria.
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How to Obtain Mezzanine Financing

Obtaining mezzanine financing is not very different from getting any other type of brand-new financing; it requires preparation, planning, and hard work.

The first step is to clearly identify the company’s financing need. This means that you would need to create a complete financial model of your company. The model (the industry standard is to use Excel) should include income statement, balance sheet, and a cash flow statement. In addition, you will need to create monthly forecasts–and not just year-end figures. Forecasts should be achievable and realistic.

In parallel with the financing model you will need to prepare a concise company presentation. It should typically include 10 to 15 slides and cover the following topics:

  • Title or cover slide
  • Company background and history
  • Business model
  • Key competitive/strategic advantage(s)
  • Sources of business stability and downside protection
  • Market overview
  • Management team
  • Funding history & shareholders
  • Current funding needs
  • Long-term plans for the company

The next step is to approach a mezzanine firm. It can be done directly or with the help of an investment bank or other corporate finance advisor. In any case, it typically takes some time, market research, and work to identify the right mezzanine financing providers for your business. You can ask for referrals from your CPA or relationship bank; there are also free resources on the internet, such as the Directory of SBIC Licensees and our list of mezzanine funds.

Most companies, after making contact with lenders and receiving initial offers, end up with very few that they want to move forward with. A good approach is to negotiate term sheets with a maximum of two to three lenders to keep the workload manageable.

Most companies will sign with only one lender. After you’ve completed the due diligence phase, you will just need to finalize the legal documentation before closing the transaction. It’s worth keeping in mind that the better organized and prepared you are will result in the deal closing more smoothly and quickly.

Image credit: teegardin.

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