A Source for Strong Start-Ups
Picture this: You own a business with a strong cash flow. You want to grow the business via an aggressive acquisition campaign. You need capital to bring your dream to reality. Above all, you want to keep control in your own hands.
Does the profile fit you? If so, you may be a good candidate for an unusual kind of capital financing more often associated with high-tech start-ups than with established small businesses engaging in ordinary commerce.
The technique goes by the name mezzanine financing, and it doesn’t work for every business. It also takes effort to raise mezzanine financing. But when the technique fills the bill, it can propel a small business to very fast growth.
In essence, mezzanine financing allows small businesses to raise capital in much the same way as big companies--by borrowing from institutional lenders such as insurers, pension funds, and bank holding companies. Unlike the deals done by big business, however, those involving small business usually combine both borrowing and equity financing.
How? In a typical deal, you raise anywhere from $1 million to $20 million, most of it in the form of debt, some in equity. Put another way, in a mezzanine deal, you borrow most of what you need and you raise the rest by selling a minority interest in your company to your lenders. The lenders earn interest on the debt plus capital gains on your stock, should it increase in value.
As a rule you pay interest only on the debt for five years or more, at a rate commonly 2 to 4 points above the interest you would pay to a bank for an ordinary commercial loan.
Thereafter, having used your capital for your acquisition campaign, you pay off the debt and buy back your stock by recapitalizing your company in a new round of financing or by going public with a stock offering.
For small businesses, many mezzanine deals package both senior and subordinated debt--that is, a layer of secured lending from commercial banks plus a layer of unsecured debt from mezzanine lenders. The mezzanine lenders commonly buy a minority interest in the borrowing company, to push total yield past 20%. Legally, secured lenders stand first in line with claims against a company’s assets, should the company go belly up; such lenders secure their position with liens on assets such as property or equipment. An unsecured lender such as a mezzanine investor stands next in line.
As a rule a company can raise two to three times cash flow in senior secured debt plus four or five times cash flow in subordinated debt. Thus a company doing $2 million in cash flow can raise $4 million to $6 million in secured debt plus $4 million to $5 million more in subordinated debt, for a total of about $10 million--five times cash flow.
If mezzanine financing sounds complicated, it is and it isn’t. These days, capital financing has become so sophisticated that no solid business, big or small, lacks options, and the big task is to school yourself in the alternatives so as to choose one that fits your need. Mezzanine financing, in other words, is only one way to raise capital.
The technique works particularly well for start-ups looking to fuel their first big spurt of growth. An established small business uses mezzanine financing when it shows solid cash flow and good prospects for growth through acquisitions, even if the business has never tapped the capital markets for any kind of financing before.
You need help, of course, in putting a deal together, starting with the key player in a mezzanine deal, an investment banker. All of the big investment banking houses do mezzanine financing deals, though rarely for small businesses; nationwide, through the middle of November, big houses such as Prudential Securities, Credit Suisse First Boston, and Morgan Stanley Dean Witter did only 22 mezzanine deals of $20 million or less, according to Securities Data Co. of Newark, New Jersey.
That doesn’t leave you with no alternatives, however. Small investment banking houses--including such Los Angeles firms as Van Kasper & Co. and Libra Investments Inc.--eagerly scout for companies ripe for mezzanine financing. Van Kasper may be reached at (310) 209-2200, Libra Investments at (310) 996-9550.
“We look for emerging-growth companies, and our minimum deal is $8 million,” says Jeri Harman, senior vice president for corporate finance at Van Kasper. “We have eight offices in California, and we deal with both public and private companies doing $10 million in revenues or more.
“We’re strong in technology companies but we also do many deals with more basic businesses.”
Jim Upchurch, president and chief operating officer of Libra Investments, does smaller deals--$2 million to $5 million--though his firm often combines with other mezzanine investors in deals raising $10 million to $15 million in all. By the end of the year Upchurch expects to complete two or three deals involving Southern California companies, with five or so more in sight for next year. Libra Investments also operates an office in New York.
The small-business owner who wants to do a mezzanine deal needs to show audited financial documents, a deep management team, strong cash flow, and a realistic business plan forecasting the prospects for the acquisition campaign, Upchurch and Harman say.
A typical mezzanine takes 90 days to complete and costs 5% of the total value of the deal in fees to the investment banking house and to legal and accounting help, both of which must be top-flight. Costs rise if the acquisition campaign targets companies with risks requiring environmental or engineering studies.
The complications notwithstanding, there is no lack of capital for companies in position to use mezzanine financing, Harman and Upchurch say. To put deals together, they tap about 50 investment funds specializing in mezzanine financing nationwide, representing capital from insurers, pension plans, bank holding companies, and other sources.
“There are plenty of banks calling on the business customer, and they’re good for ordinary borrowing,” Harman says. “But when a company is positioned for long-term growth and the owner is ready to give up some percentage of control, you need someone who knows how to do mezzanine financing.
“And in mezzanine financing, you get patient capital--someone who thinks like an equity partner. It’s great for acquisition and growth.”
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Next Week: The anatomy of a deal--how a San Diego business raised $30 million in mezzanine financing to launch an aggressive acquisition campaign and grow revenue rapidly.
Freelance writer Juan Hovey may be reached at (805) 492-7909 or by e-mail at jhovey@compuserve.com
